UDY
OF
ITERCOMWNY
PRICING
OCTOBER 18, 1988
(,^60
t ft h t ->, ^
I • w ^ 1 < I v-" w ■ '
CEO 16139?
A STUDY OF INTERCOMPANY PRICING
PREPARED BY
TREASURY DEPARTMENT
OFFICE OF INTERNATIONAL TAX COUNSEL
OFFICE OF TAX ANALYSIS
INTERNAL REVENUE SERVICE
OFFICE OF ASSISTANT COMMISSIONER (INTERNATIONAL)
OFFICE OF ASSOCIATE CHIEF COUNSEL (INTERNATIONAL)
DISCUSSION DRAFT
October 18, 1988
DEPARTMENT OF THE TREASURY
WASHINGTON
0CT181988
The Honorable Dan Rostenkowski
Chairman, Conunittee on Ways and Means
U.S. House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman:
Enclosed are three copies of a study of intercompany pricing
rules under IRC Section 482. This study was requested in the
legislative history of the 1986 Tax Reform Act and was compiled
jointly by the Treasury Department and the Internal Revenue
Service. It is scheduled to be released to the public in a press
conference at the IRS tomorrow at 11:00 a.m.
Duplicate originals of this letter and report are being sent
to the Honorable Bill Archer, ranking minority member of your
committee, the Honorable Lloyd Bentsen, Chairman, Senate Finance
Committee, and the Honorable Bob Packwood, ranking minority
member of the latter committee.
Sincerely,
0. Donaldson Ch^^oton
Assistant Secretary
(Tax Policy)
Enclosures
Lawrence B. Gibbs
Commissioner
Internal Revenue Service
cc: Ronald A. Pearlman
Chief of Staff
The Joint Coaaittet on Taxation
Section 482 White Paper
Table of Contents
(prepared by Cole Corette & Abrutyn)
I. OVERVIEW AMD BACKGROUND
Chapter 1 - OVERVIEW AMD BACKGROUMD
A. Introduction 1
B. Part I: Background 2
C. Part II: Section 482 After the 1986
Tax Reform Act 3
D. Part III: Methods for Valuing Tansfers
of Intangibles 3
E. Part IV: Cost Sharing Arrangements 4
F. Appendices 4
6. Future Agenda 5
Chapter 2 - TRAVSnit PRICIMO LAW AMD RB0ULATI0H8 BBFORB
19SC
A. Early History 6
B. Regulations and the Courts - Through the
Early 1960s 6
C. Developments in the 1960s 8
D. The Current Regulations 10
1. S«rvic«s 10
2. Intangible Property 11
S. Cmiclusion 12
Chapter 3 - XlCnff flSVICl IZTIKZXVCI XM ADMIMISTBRIMQ
8BCTI0V 412 13
A. Service's Access to Pricing Information 13
- i -
B. Intangibles
C. Application of Pricing Methods for Transfers
of Tangible Property
D. Use of Specialists and Counsel
E. Conclusions & Recommendations
-Access to pricing information
-Intangibles
-Application of pricing method for
transfers of tangible property
-Use of specialists and counsel
Chapter 4 - THB SEARCH rOR COKPARABLSS
A. Introduction
Specific comparables
Industry Statistics as Comparables
B.
C.
D.
The Regulations in the Absence of
Comparables
E. Conclusion
Chapter 5 - FOURTH METHOD XMALT8IS DWDBR 8BCTI0W 482
Introduction
Profit Splits
A.
B.
C.
D.
E.
Rate of Return; Incoae to Expense Ratios
Customs Values
Conclusion <md RecoBaendations
IT. MCTZOV 482 JLITBR TEE 1888 TAX RS70RM ACT
Chapter 8 - TH COMMIMSaRATl WZTI ZVCOMl 8TA]fDARD
A. L«9islativ« History
B. Scope of Application
19
21
24
25
25
26
27
27
28
28
28
33
34
35
36
36
36
39
43
43
45
45
48
- ii -
1. Doiible Taxation and Related Issues 48
2. Legislative Impetus 49
C. Application of Commensurate with Income
Standard to Normal Profit and High Profit
Intangibles 50
1. Normal Profit Intangibles 5j0
2. High Profit Potential Intangibles 51
D. Special Arrangements 52
1. Lump sum sales or royalties 52
2. Interaction with Section 367(d) 53
3. Cost sharing agreements 54
Chapter 7 - COMPATIBILITT WITH IMTERNATIOHAL TSAH8RR
PRZCINO 8TAKDAR08 56
A. Introduction 56
B. Th« Arm's Length Standard as an
International Nora 56
C. Reference to Profitability Under the
Arm's Length Standard 59
D. Periodic Adjustments Under the Arm's
Length Standard 61
E. Resolution of Bilateral Issues 61
F. Conclusions 62
Chapter 1 - PnZODZC ADJUSTMIKTf 63
A. Introduction 63
B. Periodic Rsvisv 66
C. Luap Sub Payments 68
D. 8«t-Offs in Royalty Arrangements 70
B. Conclusions 7i
Chapter 9 - THl MIID FOB ClRTXIBTTt ABB BATB
HXBBOBJ THB BOLUTIOM? 7 3
- iii -
A. Introduction ^^
B. General Problems With Safe Harbors 73
C. Specific Proposals ^^
1. Pricing Based on Industry Norms 75
2. Profit Split - Minimum U.S. Profit 7*5
3. Profit Split Based on Taxpayer's
Proportionate Share of Combined
Costs (ABA Proposal) 7g
4. Profit Split Based on Share of
Combined Costs and Assets (ABA
Proposal) 7g
5. Insubstantial Tax Benefit Test 76
6. Profit Distribution Test 77
7. Prior Settlement Test 77
D. Burden-Shifting Safe Harbors 77
E. Conclusions and Recommendations 78
III. METHODS FOR VALUIMO TSAMSrSSB OF HITAMOIBLBS 79
Chapter 10 - BCOMOMIC THBORIBS COHCBSVZirO IHl
IJCPLZJCZMTATIOM OF 8BCTIOM ^42 79
A. Introduction
B. The Arm's Length Approach in an Integrated
Business: Theory
C. The Arm's Length Approach in an Integrated
Business: Practice
D. Further Practical Probleas
E. Conclusions
A. Introduction
79
80
82
85
1. Monopoly Situations 85
2. Valuation of Intangibles 35
86
ChaptS r 11 - AXM'l LIVOTH MBTH0D8 FOR lyXLUATIllO
TRAMSACTZOMS IMVOLVIMO IMTAMaiBLl PROPERTY 87
87
B. Rols of Comparable Transactions 87
- iv -
1. Exact Comparables: Two Examples 87
2. Standards for Exact Comparables 88
3. Exact Comparables and Periodic
Adjustments 90
4. The Role of Inexact Comparables 90
5. Selection of Appropriate Inexact
Compareibles 91
6. Use of Inexact Comparables and
Periodic Adjustments 93
C. An Arm's Length Return Method 94
1. Basic Arm's Length Return Method 94
a. General Description 94
b. Use of Arm's Length Information 97
c. Applicability of Basic Arm's
Length Return Method 98
2. Profit Split Addition to the Basic
Arm's Length Return Method 99
3. Arm's Length Return Method and
Periodic Adjustments 102
D. Priority and Coordination Among Methods 102
E. Risk-Bearing in Related Party Situations 103
F. Coordination vith Other Aspects of
Transfer Pricing 105
G. Conclusions and Recommendations 106
ZV. COST SHARIVO ASJUOtaBMEVrS 109
Chapter 12 - HZflTORT OF COflT Smoaira 109
A. Introduction 109
B. 1966 Proposed Section 482 Regulations 110
C. Current Raguletions 110
D. Foreign Sxp«rience With Cost Sharing
111
B. Deficit Reduction Act of 1984 112
F. Cost Sharing Under Section 936(h) 112
- V -
Chapf r 13 - COST BEXRIMG X7TER THE TAX RZPORM ACT OF 1986 114
A. Introduction 114
B. Products Covered 115
C. Cost Shares and Benefits 116
1. Assignments of Exclusive
Geographic Rights 117
2. Overly Broad Agreements 118
3. Direct Exploitation of Intangibles
by Participants 118
4. Measurement of Anticipated Benefits 119
5. Periodic Adjustments 120
D. Costs to be Shared 120
E. Buy- in Requirements 121
F. Marketing Intangibles 122
G. Character of Cost Sharing Payments 123
H. Possessions Corporations 125
I. Administrative Requirements 125
J. Transitional Issues for Existing
Cost Sharing Agreements 126
K. Conclusions and Recommendations 126
APPBMDIZ A I AXILLTaZS OF QUI8TZ0MXAIRB SX8P0H8B8
A. IRS Access to Pricing Information 1
B. Application of Pricing Methods 6
C. Services 11
0. Intangibles 12
E. Use of Specialists and Counsel 14
APPSHDZl Bt 8BCTX0M 482 QUI8TZOnOLZSl - ZMTSSXXTIOMXL
WOMTKEMM
APPBIIDZZ Ct TMOnrUl PRZCZVO LAW AVD PSACTZCl 07
•ILICTID U.S. TRIATT PASTVIRS
Canada 1
France 3
Germany 4
Japan 7
United Kingdom 9
- vi -
APPENDIX Dt
AM EMPIRICAL ANALYSIS OP TBB MARKETPLACE
TOR INTANGIBLES
A. Introduction
B. Goals of Licensing Agreements
C. Payment Terms for a License
D. Provisions Which May Affect Returns
F. Conclusions and Recommendations
APPENDIX E:
EXAMPLES OF METHODS 70R VALUINO
TRAMSPERS OP INTANGIBLES
Pream±)le to Examples
Example 1: Exact Comparable
Unavailability of CompareUsles
Inexact Comparable
Likely Use of Inexact Comparable*
Example 2 :
Example 3 :
Example 4 :
Example 5:
Example 6 :
Example 7 :
Example 8:
Example 9:
Exaapla 10:
Exaapl« 11:
Basic Atb's Length Return Method:
U.S. Importer and Distributor
Basic Arm's Length Return Method:
Foreign Subsidiary Serving Local
Market
Basic Am's Length Return Method:
Foreign Subsidiary Producing for
U.S. Market
Likely Use of Basic Krm'u Length
Return Method
Likely Use of Either Inexact
Coaparables or Basic Atb's Length
R«txim Method
Profit Split Method Using Split
Observed in Arm's Length Transaction
Profit Split Method Using Information
About Relative Values of Preexisting
Intangibles
1
2
3
5
11
1
1
3
3
4
Example 12: Likely Use of Profit Split Method
13
16
- vii -
Example 13: Periodic Adjustment to Reflect Changes
in Functions 16
Example 14: Periodic Adjustments to Reflect Changes
in Indicators of Profitability 17
- viii -
I. OVERVIEW AND BACKGROUND
Chapter 1
OVERVIEW
A. Introduction
Section 482 of the Internal Revenue Code^ authorizes the
Secretary of the Treasury to allocate income, deductions, and
other tax items among related taxpayers to prevent evasion of
taxes or to reflect their incomes clearly. The Tax Reform Act of
1986 [hereinafter 1986 Act] amended section 482 for the first
time in many years by providing that the income from a transfer
or license of intangible property must be commensurate with the
income attributable to the intangible. The Conference Committee
report stated:
The conferees are also aware that many important and
difficult issues under section 482 are left unresolved by
this legislation. The conferees believe that a
comprehensive study of intercompany pricing rules by the
Internal Revenue Service should be conducted and that
careful consideration should be given to whether the
existing regulations could be modified in any respect.^
In response to this recommendation, the Internal Revenue Service
and the Treasury Department have reexamined the theory and
administration of section 482, with particular attention paid to
transfers of intangible property. This study presents the
findings and recommendations of the Service and Treasury.
The study is divided into four parts. Part I recounts the
history of section 482 and the evolution of issues leading to the
1986 amendments. Part I also contains recommendations and
suggestions for further consideration to assure both thoughtful
analysis by taxpayers in setting transfer prices and disclosure
of information to permit adequate development of transfer pricing
issues on examination.
The problems that have been encountered in relation to
transfers of intangible property are both legal and
administrative. The 1986 Act clarifies the legal standard for
determining arm's length pricing by stating that transfer prices
^ Unless otherwise stated, all references to sections and
regulations are to the Internal Revenue Code of 1986 and the
regulations promulgated thereunder.
2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 11-638
(1986) [hereinafter 1986 Conf. Rep.].
- 2 -
for intangible property must be "conunensurate with income." Part
II discusses Congress' 1986 change to section 482 and explains
that this standard requires periodic, and generally prospective,
adjustments to transfer prices to reflect significant changes in
the income attributable to intangible property. In any event,
transfer prices must be determined on the basis of true
comparables if they in fact exist. Part II concludes that the
commensurate with income standard is fully consistent with the
arm's length principle.
The primary administrative difficulty relating to transfers
of intangible property is the failure of the regulations to
specify a so-called fourth method of income allocation for
situations in which comparable transactions do not exist. This
problem has been particularly acute with respect to high profit
intangibles. Part III of the study explores the economic theory
underlying section 482 and proposes a methodology for allocating
income, and thereby determining transfer prices in such cases,
which draws upon various methods that have been used on an ad hoc
basis by the Service, taxpayers, and the courts. The methodology
would utilize functional analysis and allocate income by using
comparable transactions when they exist, arm's length rates of
return when comparables do not exist, and a profit split approach
when neither comparables nor arm's length rates of return can be
used to allocate all intangible income.
Part IV examines cost sharing arrangements and relevant
implications arising from the 1986 legislation.
The specific chapters in each part and the appendices to the
study are described below.
B. Part I ; Background
Chapter 2 reviews the history of particular transfer
pricing legislation and regulations before 1986, including
regulations promulgated in 1968, which are still in effect today.
Chapter 3 discusses administrative problems. This chapter
is supplemented by a survey of selected International Examiners
and Group Managers, summarized in Appendices A and B, which
sought information about how the section 482 regulations work in
practice. Significant problems include access to pricing
information and difficulties in applying pricing methods to
transfers of intangible assets. The chapter includes
recommendations regarding the maintenance of transfer pricing
information in the taxpayer's books and records, which would be
required to be provided to the IRS immediately upon request in an
examination, summary reporting of the taxpayer's transfer pricing
methodology on Forms 5471 and 5472, and the assertion of
appropriate penalties for failure to disclose information or for
substantial understatements of income.
- 3 -
The regulations place strong emphasis on finding comparable
unrelated party transactions as a guide for evaluating related
party transactions. Chapter 4 discusses the search for
comparables in the decided cases, and concludes that comparables
are often either absent or misused when transfers of intangible
property are at issue.
The regulations provide that, when comparables are
unavailable, some other appropriate method of allocating income
among related parties may be used. Chapter 5 examines the
decided cases to see what other methods have been used, including
profit splits, rates of return, income to expense ratios, and
customs valuations.
C. Part II: Section 482 After the 1986 Tax Reform Act
Chapter 6 focuses on the "commensurate with income"
standard incorporated into section 482 by the 1986 Act. After
describing the legislative history, the chapter discusses
limitations some have suggested on the scope of the standard, and
explains its application to normal profit potential intangibles
as well as to high profit potential intangibles.
Chapter 7 addresses an issue of major concern to the foreign
trading partners of the United States: compatibility with
international transfer pricing standards. The chapter concludes
that the arm's length standard is the accepted international norm
for making transfer pricing adjustments. The study reaffirms
that Congress intended the commensurate with income standard to
be consistent with the arm's length standard, and that it will be
so interpreted and applied by the Internal Revenue Service and
the Treasury Department. ,
Chapter 8 discusses the need under the commensurate with
income standard to make periodic adjustments to intangible income
allocations. Recommendations address the issues of the frequency
of review, retroactivity, lump sum payments, and set-offs.
Taxpayers and practitioners have long advocated safe harbors
as a solution to many of the problems arising under section 482.
Chapter 9 discusses safe harbors in theory and analyzes some of
the safe harbors that have been proposed. While the Service and
Treasury do not categorically reject the possibility that some
useful safe harbors might be developed, none of those currently
proposed appears satisfactory.
D. Part III: Methods for Valuing Transfers of Intangibles
The current regulations adopt a market-based approach,
distributing income among related parties the way a free market
would distribute it among unrelated parties. Some critics have
- 4 -
suggested that a unitary business approach, eliminating the
fiction of arm's length dealing and accounting for economies of
related party dealing through a formulary method, might be more
theoretically sound. Chapter 10 examines these arguments and
concludes that the market-based arm's length standard remains the
better theoretical allocation method.
Chapter 11 discusses the formulation of a methodology for
applying the arm's length standard to transfers of intangible
property. Beginning with a discussion of the use of exact and
inexact comparables, the chapter proposes as an additional method
an arm's length return method that, with appropriate adjustments,
could be used in a large percentage of cases. For cases
involving intangibles in which comparables and the arm's length
return method cannot account for all income to be allocated, a
profit split addition to the arm's length return method is
described.
E. Part IV: Cost Sharing Arrangements
Chapter 12 presents a description of cost sharing
arrangements and describes the history of their tax treatment,
comparing the detailed section 482 cost sharing regulations that
were proposed in 1966 with the terse version actually promulgated
in 1968. The chapter reviews foreign experience with cost
sharing, a 1984 Congressional recommendation that the cost
sharing rules be expanded, and the special rules governing cost
sharing arrangements between possessions corporations and their
domestic affiliates.
The legislative history regarding the change to section 482
in the 1986 Act states that Congress intended to permit bona fide
cost sharing arrangements, but expected the economic results of
such arrangements to be consistent with the commensurate with
income standard. Chapter 13 identifies and discusses various
issues related to the use of cost sharing arrangements after the
1986 Act.
F. Appendices
Appendices A and B to the study summarize the results of a
survey of Service personnel about the administration of section
482. Appendix C analyzes the transfer pricing law and practices
of selected jurisdictions. Appendix D describes the publicly
available information about third party licensing practices.
Appendix E contains 14 examples that illustrate how the
principles explained in the study are applied in different
factual contexts.
- 5 -
G. Future Agenda
This study reflects input from taxpayer groups,
practitioners, and other concerned members of the public, as well
as the combined experience and careful thought of those in the
government charged with enforcing section 482. Nevertheless, it
is only a beginning; it sets forth conclusions and
recommendations in some areas, and describes the need for further
study in others.
In the study, input is requested on specific issues from
taxpayers and practitioners. More generally, however, readers
are urged to provide any comments that would be useful in
formulating a fair and workable system of administering a statute
that has challenged taxpayers and the government alike. It is
anticipated that comments will be taken into account in drafting
proposed regulations and in examining additional issues not
discussed in this study -- including such areas as the services
portion of the section 482 regulations, the impact of currency
fluctuations on transfer pricing, a more detailed review of
functional analysis, and the proper methodology for valuing
assets under the various "fourth method" approaches described in
Chapter 11.
Comments should be forwarded in triplicate to the Office of
Associate Chief Counsel (International), Branch 1, 950 L' Enfant
Plaza South, S.W., Room 3319, Washington, D.C. 20024. Comments
are requested to be filed by February 15, 1989.
- 6 -
Chapter 2
TRANSFER PRICING LAW AND REGULATIONS BEFORE 1986
A. Early History
The Commissioner was generally authorized to allocate income
and deductions among affiliated corporations in 1917.^ He could
require related corporations to file consolidated returns
"whenever necessary to more equitably determine the invested
capital or taxable income...." The earliest direct predecessor
of section 482 dates to 1921, when legislation went beyond
authority to require consolidated accounts and authorized the
Commissioner to prepare consolidated returns for commonly
controlled trades or businesses to compute their "correct" tax
liability.* This legislation was passed partly because
possessions corporations, ineligible to file consolidated returns
with their domestic affiliates, offered opportunities for tax
avoidance.^ As early as 1921, Congress perceived the potential
for abuse among related taxpayers engaged in multinational
transactions.
When the predecessor to current section 482 was incorporated
into the 1928 Revenue Act (as section 45), the provision was
removed from the expiring consolidated return provisions and
significantly expanded.' The Commissioner's authority to make
an adjustment under section 45 was expressly predicated upon his
duty to prevent tax avoidance and to ensure the clear reflection
of the income of the related parties (to determine their "true
tax liability," in the words of the legislative history).'
B. Regulations and the Courts — through the early 1960s
For many years, the small number of United States companies
with multinational affiliates meant that section 482 had little
impact in the international context. Prior to the early 1960s,
the primary focus of the Service's enforcement efforts using
3 Regulation 41, Articles 77-78, War Revenue Act of 1917,
ch. 63, 40 Stat. 300 (1917).
* Rev. Act of 1921, ch. 136, §240(d), 42 Stat. 260 (1921)
5 S. Rep. No. 275, 67th Cong., 1st Sess. 20 (1921).
* Rev. Act of 1928, ch. 852, §45, 45 Stat. 806 (1928).
' H.R. Rep. No. 2, 70th Cong., 1st Sess. 16-17 (1928).
- 7 -
section 482 was domestic. Regulations issued in 1935® (under
section 45) remained in effect substantially unchanged until
1968.
The regulations set forth the arm's length standard as the
fundamental principle underlying section 482: "The standard to
be applied in every case is that of an uncontrolled taxpayer
dealing at arm's length with another uncontrolled taxpayer."'
They did not, however, mandate the use of any particular
allocation method.
The case law interpreting section 482 and its predecessors
took a broad approach. The concepts of "evasion of taxes "^° and
"clear reflection of income"^ ^ were developed into far-reaching
weapons to attack a variety of tax abuses. The predecessors of
section 482 were used to prevent recognition of a tax loss on
securities following a tax-free transfer from the corporation
that had incurred, but could not use, the loss,^^ and to prevent
the mismatching of the expenses incurred by one corporation in
growing crops from the income artificially realized by another
corporation from harvesting and selling those crops. ^^
The courts applied a number of different standards for
determining when transactions were conducted at arm's length.
» Treas. Reg. 86, §45-l(b) (1935).
' Id.
^° Asiatic Petroleum Co. v. Comm'r , 79 F.2d 234, 236 (2d
Cir.), cert , denied, 296 U.S. 645 (1935) (concept of evasion for
this purpose includes civil tax avoidance).
^^ Central Cuba Sugar Co. v. Comm'r , 198 F.2d 214, 215 (2d
Cir.), cert, denied, 344 U.S. 874 (1952) (application of clear
reflection standard does not require proof of tax avoidance
motive ) .
^^ National Securities Corp. v. Comm'r , 137 F.2d 600 (3d
Cir.), cert , denied , 320 U.S. 794 (1943).
^^ Central Cuba Sugar , supra n. 11; Rooney v. U.S. , 305
F.2d 681 (9th Cir. 1962).
- 8 -
Transactions were scrutinized to determine if related parties
received full, fair value, ^* a fair and reasonable price, ^^ or a
fair price including a reasonable profit.^*
Before 1964, it was generally understood that section 482
could not be used by the Service to place taxpayers, in effect,
on a consolidated return basis. ^' In 1964, the Tax Court used
section 482 to combine the incomes of two separate corporations
that operated a downtown clothing store and its suburban branch
store. ^® This case raised concerns among taxpayers over the use
of section 482 in substance to ignore separate corporate
entities.
C. Developments in the 1960s
By the early 1960s, the business and regulatory climate in
which U.S. and foreign multinationals operated changed
substantially. In 1961, the Treasury Department urged that
significant changes be made in the taxation of U.S. enterprises
with foreign affiliates. In particular. Treasury contended that
section 482 was not effectively protecting U.S. taxing
jurisdiction.^'
^* Friedlander Corp. v. Comm'r , 25 T.C. 70, 77 (1955).
15 Polack's Frutal Works v. Comm'r , 21 T.C. 953, 975 (1954).
1^ Grenada Industries v. Comm'r ,- 17 T.C. 231 (1951), aff 'd ,
202 F.2d 873 (5th Cir.), cert , denied , 346 U.S. 819 (1953).
1^ Seminole Flavor Co. v. Comm'r , 4 T.C. 1215 (1945); cf .
Moline Properties v. Comm'r , 319 U.S. 436 (1943). In extreme
cases of income shifting, other legal theories such as assignment
of income, substance over form, disregard of corporate entity, or
treatment of corporate entity as an agent have been used by
courts to attribute income to the appropriate person or corporate
entity. These theories are beyond the scope of this paper, and
they are generally not used by courts when section 482 is also
applicable. See , e.g. , Hospital Corporation of America v.
Comm'r , 81 T.C. 520 (1983) (foreign affiliate not treated as a
sham; section 482 applied for use of U.S. parent's intangibles).
18 Hamburgers York Road, Inc. v. Comm'r , 41 T.C. 821
(1964); Aiken Drive- In Theatre Corp. v. U.S. , 281 F.2d 7 (4th
Cir. 1960) (the shifting of an abandonment loss from one
corporation to another created an inaccurate picture of income,
justifying use of section 482).
1' Hearings on the President's 1961 Tax Recommendations
Before the Committee on Ways and Means , 87th Cong., 1st Sess.,
vol. 4, at 3549 (1961) (statement of M. Caplin, Commissioner of
- 9 -
In 1962, Congress considered how to stop U.S. companies
from shifting U.S. income to their foreign subsidiaries.^ ° While
the Ways and Means Committee observed that under existing law the
Service could prevent this practice by allocating income under
section 482, it proposed further legislation to minimize "the
difficulties in determining a fair price, " particularly in
instances "where there are thousands of different transactions
engaged in between a domestic company and its foreign
subsidiary. "^i
The Ways and Means Committee proposal as adopted by the
House would have added to section 482 a new subsection dealing
with sales of tangible property between U.S. corporations and
their foreign corporate af filiates. ^^ Unless the taxpayer could
demonstrate its use of an arm's length price under the comparable
uncontrolled price method, taxable income was to be apportioned
between related parties under a formula based on their relative
economic activities. In addition, no income was to be allocated
to a "foreign organization whose assets, personnel, and office
and other facilities which are not attributable to the United
States are grossly inadequate for its activities outside the
United States. "^^
The Senate version of the 1962 Revenue Bill, which prevailed
in conference, omitted the House provision. Instead, the Finance
Committee concluded that section 482 already provided ample
regulatory authority to prevent improper multinational
allocations.^* The Conference Committee endorsed this approach,
stating:
The conferees on the part of both the House and the
Senate believe that the objectives of section 6 of the
bill as passed by the House can be accomplished by
amendment of the regulations under present section 482.
Internal Revenue, "Problems in the Administration of the Revenue
Laws relating to the Taxation of Foreign Income").
20 H.R. Rep. No. 1447, 87th Cong., 2d Sess. 28 (1962).
2 1 Id.
22 H.R. 10650, 82d Cong., 2d Sess., §6 (1962).
2 3 Id.; see H.R. Rep. No. 1447, 87th Cong., 2d Sess.
537-38 (1962).
2* See, e.g. , Hearings on H.R. 10650 Before the Senate
Committee on Finance , 87th Cong., 2d Sess., pt. 7, at 2913, 3011-
3012 (1962) (statements by P. Seghers and D. N. Adams).
- 10 -
Section 482 already contains broad authority to the
Secretary of the Treasury or his delegate to allocate
income and deductions. It is believed that the
Treasury should explore the possibility of developing
and promulgating regulations under this authority which
would provide additional guidelines and formulas for
the allocation of income and deductions in cases
involving foreign income,^ ^
D. The Current Regulations
Treasury responded by promulgating regulations, issued in
final form in 1968, that (with only a few changes) govern
transfer pricing practices today. ^^ Those regulations reaffirmed
the arm's length standard as the principal basis for transfer
pricing adjustments but attempted, for the first time, to
establish rules for specific kinds of intercompany transactions.
The final regulations applied to the performance of services, the
licensing or sale of intangible property, and the sale of
tangible property. ^^
1. Services . In determining an arm's length charge for
services, section 1 .482-2(b) (3 ) of the regulations provides:
For the purpose of this paragraph an arm's length charge for
services rendered shall be the amount which was charged or
would have been charged for the same or similar services in
independent transactions with or between unrelated parties
under similar circumstances considering all relevant facts.
The regulations do not provide any specific guidance for
determining what the charge in independent transactions would
have been in the absence of comparable transactions with
independent parties.
25 H.R. Rep. No. 2508, 87th Cong., 2d Sess. 18-19 (1962).
^* Proposed regulations were issued in 1965, were withdrawn
and reproposed in 1966, and were issued in final form in 1968.
Proposed Treas. Reg. §§1.482-l(d) and 2, 30 Fed. Reg. 4256
(1965); Proposed Treas. Reg. §§1.482-l(d) and 2, 31 Fed. Reg.
10394 (1966); and T.D. 6952, 1968-1 C.B. 218.
2^ In addition to the tangible and intangible property and
the services regulations, there are safe harbors and other rules
for interest rates on related party loans, Treas. Reg. §1.482-
2(a), and rules similar to the services rules for related party
leasing transactions, Treas. Reg. §1.482-2(c). These rules are
generally not discussed in this paper.
- 11 -
2. Intangible Property . As to the licensing or sale of
intangible property, section 1 . 482-2( d) ( 2 ) ( ii ) of the regulations
provides:
In determining the amount of an arm's length consideration,
the standard to be app-ied is the amount that would have
been paid by an unrelated party for the same intangible
property under the same circumstances. Where there have
been transfers by the transferor to unrelated parties
involving the same or similar intangible property under the
same or similar circumstances the amount of the
consideration for such transfers shall generally be the best
indication of an arm's length consideration.
The intangible property portion of the regulations contemplate a
failure to find appropriate comparables. Where they are
unavailable, the regulations list 12 factors to be taken into
account, including prevailing rates in the industry, offers of
competitors, the uniqueness of the property and its legal
protection, prospective profits to be generated by the
intangible, and required investments necessary to utilize the
intangible.^ ^ The regulation offers little or no guidance,
however, in determining how much relative importance particular
factors are to be given.
3. Tangible Property . Finally, the section 482 regulations
set out detailed rules for determining the transfer prices of
tangible personal property. Section 1.482-2( e ) ( 2 ) (4 ) of the
regulations describes three specific methods for determining an
appropriate arm's length price: the comparable uncontrolled
price method, the resale price method, and the cost plus method.
All three rely on comparable transactions to determine an arm's
length price, either directly or by reference to appropriate
markups in comparable unrelated transactions. The regulations
mandate that the three enumerated methods be used in the order
set forth. They also authorize other unspecified methods, which
have come to be known generically as "fourth methods":
Where none of the three methods of pricing . . . can
reasonably be applied under the facts and circumstances as
they exist in a particular case, some appropriate method of
pricing other than those described in subdivision (ii) of
this subparagraph, or variations on such methods, can be
used. [Emphasis supplied.]^'
The specific transaction-oriented models described above for
making transfer pricing determinations were adopted in lieu of
28 Treas. Reg. §1 . 482-2( d) ( 2 ) ( iii ) .
29 Treas. Reg. §1 . 482-2( e ) (1 ) ( iii ) .
- 12 -
"mechanical safe havens" based on profit margins, percentage
mark-ups or mark-downs, and the like, which had been suggested by
various taxpayers commenting on proposed regulations issued in
1955 and 1966. Such safe harbors were rejected for two reasons.
First, because of the extraordinary range of returns earned at
arm's length, even within a single industry or company, no
principled and equitable basis for such safe harbors could be
devised. Second, any effective safe harbor income allocation
would inevitably serve as a "floor," applying only to those
taxpayers not able to document a more advantageous fact
pattern.-' ° As discussed in Chapter 9, infra , the concerns
raised by safe harbors still have not been satisfactorily
dispelled.
E. Conclusion
In general, the section 482 regulations relating to
services, intangible property, and tangible property rely
heavily on finding comparable transfer prices or comparable
transactions. The regulations provide little guidance for
determining transfer prices in the absence of comparables.
^** Surrey, Treasury's Need to Curb Tax Avoidance in
Foreign Business through the Use of Section 482 , 28 J. Tax'n 75
(1968).
- 13 -
Chapter 3
RECENT SERVICE EXPERIENCE IN ADMINISTERING SECTION 482
In order to determine what difficulties International
Examiners are encountering in administering the regulations, a
questionnaire was prepared through the joint efforts of Treasury,
Chief Counsel, and International Examination personnel. The
questionnaire was sent to selected International Examiners ( lEs )
and IE Group Managers. In addition, selected IRS economists,
IBs, Group Managers, and IRS trial attorneys were interviewed.
The results of the analysis of the questionnaires have been
compiled and are set forth in Appendix A. Included in Appendix B
is a completed questionnaire reflecting the aggregate data
supplied by the respondents.^^ In general, the survey and
interviews revealed no surprises. The two primary problems in
administering section 482 have been the difficulty of obtaining
pricing information from the taxpayers during an examination and
the difficulty of valuing intangibles — including the valuation
of intangible property in connection with sales of tangible
property. This chapter discusses these problems, makes several
related suggestions regarding disclosure of information and
penalties, and suggests that the early use of counsel and
economic experts would alleviate these problems.
A. Service's Access to Pricing Information
A significant threshold problem in the examination of
section 482 cases has been IRS access to relevant information to
make pricing determinations. In some cases, relevant information
^ ^ IBs and Group Managers were requested to complete one
questionnaire for each of the three cases they considered to be
their most important section 482 cases. In some instances
respondents had not had experience with three important section
482 cases, so that fewer responses were made to some questions.
In others, some respondents answered based on their general
experience, rather than the particular case for which the
questionnaire was completed. In many instances the
categorization of particular issues entails a great deal of
judgment. For example, a case such as Hospital Corporation of
America , supra n. 17, could be viewed as a services case, an
allocation of income case, a profit split case, or an
intangibles case. For these reasons we have used the results of
the questionnaire throughout this paper primarily for purposes of
illustration. However, the results, where used, represent and
correspond with the experiences of persons interviewed and
others in the Service responsible for administering section 482.
- 14 -
is not furnished by the taxpayer to the examining agent. ^^ In
other cases, long delays are experienced by agents in receiving
information, in most cases without explanation for the delays.
In many cases, delays in responding to IE requests for
information exceed one year,-'^ Because of the emphasis upon
timely closing of large cases in the recent past, section 482
cases have been closed without receiving necessary information or
without the opportunity for agents to follow up on information
that has been provided.^*
The experience of the agents has been that the vast majority
of taxpayers, when asked, are unable to provide an explanation
of how their intercompany pricing was established.^^ This may
account in large part for the denial of access to information and
delays encountered by lEs.
In recent years the Service has placed an emphasis on
examination of transactions with subsidiaries located in tax
haven jurisdictions.^^ Because of the financial and commercial
secrecy laws that exist in tax haven jurisdictions, IRS access to
third party data has been significantly hampered. Problems with
access to information because of foreign secrecy laws have been
to some extent alleviated by the enactment of section 982^' and
by a broad interpretation of the IRS administrative summons power
^ 2 Many of the requests for information that are not
honored concern transactions with third parties that would
provide comparables for analyzing a potential section 482
adjustment. Appendix B, infra , at Question 18C.
^^ Appendix B, infra, at Question 19.
^* Appendix B, infra, at Question 13, and Appendix A,
infra , at 4-5.
^^ Appendix B, infra, at Question 14.
^* General Accounting Office, Report to the Chairman,
Committee on Ways and Means, IRS Audit Coverage: Selection
Procedures Same for Foreign and other U.S. Corporations 26-29
(1986) [hereinafter GAO, IRS Audit Coverage ] .
^' Under section 982, a taxpayer which, without reasonable
cause, fails to produce, within 90 days, foreign based documents
sought by the agent during the course of the examination through
the use of a formal document request may be precluded from
introducing the documents sought in a subsequent court
proceeding. A special court proceeding is established at which
the taxpayer may show reasonable cause for failing to produce the
requested documents or otherwise move to quash the formal
document request.
- 15 -
by the courts.^* However, as will be subsequently discussed,
agents have failed to use the section 982 and administrative
sununons procedures aggressively.
Because of the dramatic increase in recent years in direct
foreign investment in the United States,^' the examination of
transactions between foreign parents and their U.S. affiliates
will become an increasingly more important part of the
international examination program. A survey of rates of return
on these companies based on IRS statistics of income ("SOI")
data reveals a substantially lower than average profit in this
country reported by these companies, which may involve transfer
pricing policies.* °
In practice, examinations of United States subsidiaries of
foreign parents have developed into some of the Service's most
difficult examinations. A primary reason for the difficulty is
that agents are unable to obtain timely access to necessary
data, which is typically in the hands of the parent company. In
many cases, foreign parent companies refuse to produce this
information upon request. An additional difficulty encountered
by agents is that foreign parent corporations may not be subject
to information reporting requirements similar to U.S.
requirements . * ^
Both the administrative summons procedures* ^ and the formal
document request procedures* ^ are tools that are available to lEs
to compel production of information necessary to determine
whether a section 482 adjustment is appropriate. Unfortunately,
3 8 Vetco V. United States , 644 F.2d 1324 (9th Cir. 1981),
cert, denied , 454 U.S. 1098 (1982) (summons for books and records
of Swiss controlled foreign corporation enforced notwithstanding
potential violations of the Swiss Penal Code).
3' Foreign direct investment in the United States increased
from about $34.6 billion in 1977 to about $100.50 billion in
1984. GAG, IRS Audit Coverage , supra n. 36, at 10.
*° Hobb, Foreign Investment and Activity in the United
States through Corporations, 1983 , SOI Bulletin 53-68 (Summer
1987); see BNA Daily Tax Report , April 1, 1987, at G2.
*^ Wheeler, SEC Requires Less Disclosure from Foreign
Corporations , Tax Notes, October 12, 1987, at 195-197.
*2 Section 7602; United States v. Toyota Motor Corp ., 561
F. Supp. 348 (CD. Cal. 1983); United States v. Toyota Motor
Corp . , 569 F. Supp. 1158 (CD. Cal. 1983).
*3 Section 982.
- 16 -
for a variety of reasons, lEs seldom serve administrative
summonses or section 982 requests.** The most common reason
given for failing to use these procedures is the time delay
necessary to follow them, which conflicts with the need to close
the examination. Another reason given in many cases was the
necessity of maintaining a good working relationship with the
taxpayer, which lEs feared would be harmed if these procedures
were used.
Although section 6001 contains a general requirement that a
taxpayer maintain adequate books and records, the section 482
regulations are generally silent with regard to records and their
accessibility to either support or to determine arm's length
prices.*^ Thus, the current regulations do not advise taxpayers
specifically of the type of information that is necessary in
order to determine compliance with section 482. Specific
information on transactions between parent and subsidiary
corporations is required on forms 5471 and 5472, which have been
widely used by agents in planning and conducting section 482
examinations .
Service experience has been that many taxpayers do not rely
upon any form of comparable transactions or other contemporaneous
information either in planning or in defending intercompany
transactions.*' Although the legislative history to the 1986 Act
expresses concern that industry average royalty rates are used by
taxpayers to justify royalties for high profit intangibles,*^ the
more serious problem has been that the taxpayer, not having
structured the transaction with any comparable in mind, seeks to
defend its position by finding whatever transaction or method
gets closest to the transfer price initially chosen, whether that
be an industry average rate of return or some other type of
comparable.
** In the survey conducted as part of this study, lEs
reported using summonses and section 982 requests in
approximately 5% and 4%, respectively, of the cases reported in
the survey. Appendix B, infra , at Questions 21, 22.
*5 An exception in Treas. Reg. §1.482-2(b)(7 ) requires
adequate records to verify costs or deductions used in connection
with a charge for services to an affiliate.
** Appendix B, infra , at Question 57.
*^ H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985)
[hereinafter 1985 House Rep.]. The survey revealed that in
approximately 41% of the cases in which taxpayers relied upon
comparables, industry averages were used. Appendix A, infra .
- 17 -
Problems related to information and aggressive return
positions would be alleviated if the regulations specifically set
out a taxpayer's responsibility to document the methodology used
in establishing intercompany transfer prices prior to filing the
tax return and to require that such documentation be provided
within a reasonable time after request. The documentation should
include references to any comparable transactions, rates of
return, profit splits, or other information or analyses used by •
the taxpayer in arriving at transfer prices. In general, a
taxpayer making relatively minor investments would not be
required to obtain information regarding comparable transactions
outside of its own knowledge of its business affairs and those of
its competitors, but to use information and analyses that
generally would have been produced by the taxpayer in the course
of developing its business plan. However, a taxpayer engaging in
a major transaction or one involved in a complex profit split
analysis involving significant high profit intangibles*® would be
expected to gather and analyze the types of information
illustrated by the examples in Appendix E which, once again, is
information likely to be produced by the taxpayer in developing
its business plan. In the absence of comparables, taxpayers
should be required at a minimum to apply a rate of return
analysis or profit split methodology that may be prescribed in
regulations under which the taxpayer would identify assets and
functions performed by it and its affiliates and identify the
rate of return or profit split that the taxpayer believes should
be assigned or allocated to each activity or function.
Furthermore, Forms 5471 and 5472 should be revised to
include summary information describing how intercompany prices
were determined and an attestation that the documentation
required to be maintained under the section 482 regulations, as
described above, was available at the time of preparation of the
return and will be made available at the start of an IRS
examination. Requiring information to be made available at the
beginning of an audit would alleviate problems of receiving
either too little or too much information near the expiration of
the statute of limitations.
The Service and Treasury believe that taxpayer compliance in
the transfer pricing area with respect both to disclosure of
information and to confoirmity with the arm's length standard
would be enhanced by the proper assertion of appropriate
penalties. While the penalty imposed by section 6561 for
substantial understatement of tax can apply, to date the Service
has only infrequently imposed penalties in connection with making
*® See discussion infra Chapter 11.
- 18 -
section 482 adjustments.^' The Internal Revenue Service is
currently engaged in a comprehensive study of the role of civil
tax penalties, ^° as are many other interested parties. It,
therefore, seems timely to focus now on the effectiveness of
existing penalties in encouraging compliant taxpayer behavior and
penalizing unjustified positions in the transfer pricing area.
Consideration should be given to when the section 6661 penalty
should be raised and whether it is adequate to deter instances
where taxpayers do not make intercompany pricing decisions upon a
reasonable basis, or whether a new penalty should be proposed.
The Service and Treasury are interested in recommendations
in this area, including such specific comments as to the type and
amount of penalties, and whether there should be certain
transaction oriented thresholds that ought to apply before any
penalty could be asserted. For example, a transaction specific
penalty (similar to the overvaluation penalty of section 6659)
may be an appropriate means of deterring substantial deviations
from the commensurate with income standard. Specific
consideration should be given to whether the applicable penalty
provisions should be amended to apply if there is a substantial
deviation from the appropriate commensurate with income payment
regardless of whether there is disclosure on the tax return of
the manner in which taxpayers computed transfer prices.
Disclosure of the taxpayer's method of computing a transfer price
can not adequately inform the Service as to whether such a
transfer price substantially deviates from the appropriate
section 482 transfer price absent a thorough audit.
Consequently, such disclosure should not prevent the imposition
of a penalty for substantial deviation from the correct section
482 transfer price. ^^ Since it is possible to use the provisions
of section 367(d) to deter abusive situations (see discussion of
section 367(d) infra Chapter 6), it may also be appropriate to
clarify how taxpayers may avoid imposition of penalties in the
context of section 367 adjustments.
*' Under Rev. Proc. 88-37, 1988-30 I.R.B. 31, a taxpayer
that reports intercompany transactions, on Schedules G and M of
Form 5471, may avoid the substantial understatement penalty. See
Rev. Proc. 85-26, 1985-1 C.B. 580 (amended returns or statements
made following commencement of a CEP examination may avoid
assertion of the substantial understatement penalty).
5° Commissioner's Penalty Study, A Philosophy of Civil Tax
Penalties (discussion draft June 8, 1988).
^^ See discussion of the commensurate with income standard
and periodic adjustments infra Chapters 6 and 8.
- 19 -
B. Intangibles
A significant portion of section 482 adjustments proposed in
recent years have involved an adjustment for pricing with respect
to the licensing or other transfer of intangibles.^^ Because of
the absence of comparables in many cases, intangible transfers
generally are the most problematic of adjustments due to the
inherent difficulty of valuing intangibles under the existing
regulations. As previously noted in Chapter 2, the intangible
property portion of the regulations contemplate a failure to find
appropriate comparables and list 12 factors to be taken into
account in valuing intangibles in the absence of comparables. No
guidance is given, however, in determining the relative
importance of particular factors.
In a significant number of cases, lEs relied upon sections
of the regulations other than the intangibles portion to make a
transfer pricing adjustment. ^ ^ Intangibles are often transferred
by incorporation into tangible property that is sold or rented.
In these types of cases, the taxpayers have not been required to
isolate the value of the intangible.^* Incorporating a return on
an intangible in a transfer price for tangible property does not
alleviate, however, the difficulty of valuing the intangible.
A common example is the transfer of tangible property with a
trademark, trade name, or recognizable logo attached. It is
clear from the regulations that a trademark, trade name, or logo
is an intangible.^ ^ The regulations governing the sales of
tangible property specify that, in applying the comparable
uncontrolled price, resale price, and cost plus methods,
adjustments must be made for sales with or without trademarks,
provided there is a reasonably ascertainable effect on the
price. ^* In some cases adjustments for trademarks are relatively
easy to make. The analysis, however, becomes much more complex
If there are no similar products sold (with or without
^^ In the survey conducted for the study, an adjustment was
made under Treas. Reg. §1.482-2(d) in about 50% of the reported
cases. Appendix B, infra , at Question 68.
^^ In approximately 40% of the cases reported in the
survey, lEs cited the inability to value an intangible as the
reason why they failed to follow the Intangibles section of the
regulations. Appendix B, infra , at Question 72.
5* Rev. Rul. 75-254, 1975-1 C.B. 243.
55 Treas. Reg. §1 . 482-2( d ) ( 3 ) .
5' See , e.g. , Treas. Reg. §§1 , 482-2( e ) ( 2 ) ( 11 ) and example
(2), 1.482-2(e)(3)(ii) example (2), and 1 . 482-2( e ) ( 4 ) ( ill ) ( c ) .
- 20 -
trademarks) on which to base a comparison. Setting a transfer
price for a product in such a case involves the same difficult
exercise as setting a royalty rate for a licensed intangible.
One of the recent pharmaceutical cases presents an example of
this latter situation since it involved the sale of unique
pharmaceutical products.^'
Intangibles may also be transferred in the form of services.
In some circvunstances, taxpayers have attempted to shift large
amounts of income to tax haven subsidiaries by "loaning" a few
key employees to a tax haven affiliate. By loaning employees,
the parent company may simultaneously provide services and
transfer valuable intangible know-how. In transactions which are
structured as an intangibles transfer, it is difficult to value
services rendered in connection with the transfer of intangible
property, which may be necessary for purposes of determining the
source of the income.^*
A particularly difficult aspect of valuing intangibles has
been determining what part of an intangible profit is due to
manufacturing intangibles and what part is due to marketing
5' Eli Lilly & Co. v. Comm'r , 84 T.C. 996 (1985), rev'd in
part , aff'd in part and remanded , Nos. 86-2911 and 86-3116 (7th
Cir. August 31, 1988) [ Lilly ] . See the discussion of Lilly ,
infra . Chapters 4 and 5.
5* In certain circumstances, no separate allocation is
required for services performed in connection with the transfer
of intangible property. Treas. Reg. S1.482-2(b) ( 8 ) . Services
are rendered in connection with the transfer of intangible
property if they are merely ancillai-y or subsidiary to the
transfer of the intangible property. The regulations give as an
example of ancillary services start-up help given to a related
entity in order for it to integrate a trade secret manufacturing
process into its operations. The regulations then state that,
should the transferor continue to render services after the
process has been integrated into the manufacturing process, a
separate allocation for services would be recpuired under the
regulations. The experience of the lEs is that the current
regulations fail to give them specific guidance on how to
determine when services rendered in connection with the transfer
of an intangible require a separate allocation.
Appendix D discusses results of a preliminary survey of data
available at the SEC. This data has the potential to determine
when unrelated parties would extract a specific charge for
services rendered in connection with the transfer of an intangible,
- 21 -
intangibles.^' This problem has particular significance in
section 936, since the possessions corporation is generally
entitled to a return only on manufacturing intangibles when it
elects the cost sharing method under section 936(h).
Problems with intangibles underlie the amendment made to
section 482 by the 1986 Act, as discussed in Part II. The
intangibles section of the section 482 regulations should be
modified to provide a specific analysis to be used when
comparable uncontrolled transactions do not exist. The method
should provide for appropriate allocations of income when
multiple intangibles (such as marketing and manufacturing
intangibles) are present in the same set of transactions. Part
III is devoted to the subject of an appropriate methodology for
allocating intangible income.
C. Application of Pricing Methods for Transfers of Tangible
Property
When considering an adjustment with respect to the transfer
price for tangible property, the regulations require both the
taxpayer and the Service to follow a priority of pricing methods:
first, the comparable uncontrolled price method must be
attempted, then resale price method, then cost plus method, and,
if none of them are applicable, some other method or combination
of the prior methods.^ ° Five prior studies using data available
from both the Service and multinational corporations have
examined the frequency with which each of these methods has been
used. The results of these surveys are set forth below:
5' In Lilly , supra n. 57, the Tax Court ultimately
determined the parent company's marketing return based upon using
its "best Judgment." Lilly , 84 T.C. at 1167; See also G. D.
Searle and Co. v. Comm'r [Searle] , 88 T.C. 252, 376 (1987).
*° Treas. Reg. §§1 .482-2(e ) ( 1 ) ( ii ) and (iii).
- 22 -
Report
1973 Treas. Report '^
Conference Bd Report ^^
Burns Report * ^
GAO ^*
1984 IRS Survey* 5
1987 IRS Survey
(overall )
1987 IRS Survey*'
(tangible property)
Percentage of Cases in which Various
§ 482 Pricing Methods Were Used
CUP
20
28
24
15
41
32
31
Resale
Cost Plus
Other
11
27
40
13
23
36
14
30
32
14
26
47
7
7
45
8
24
36
18
37
14
*^ Treasury Department News Release, Summary Study of
International Cases Involving Section 482 of the Internal Revenue
Code (Jan. 8, 1973), reprinted in 1973 Standard Federal Tax
Report (CCH) par. 6419.
* 2 Tax Allocations and International Business: Corporate
Experience with Section 482 of the Internal Revenue Code ,
Conference Board Report No. 555 (1972).
* ^ Bums , How IRS Applies the Intercompany Pricing Rules of
Section 482: A Corporate Survey . 54 J. Tax'n 308 (1980).
** General Accounting Office, Report by the Comptroller
General to the Chairman, House Committee on Ways and Means, IRS
Could Better Protect U.S. Tax Interests in Determining the Income
of Multinational Corporations (1981) [hereinafter GAO, IRS Could
Better Protect U.S. Tax Interests ] .
*^ IRS Publication No. 1243, IRS Examination Data Reveal an
Effective Administration of Section 482 Regulations (1984).
** As stated earlier, the percentages from the 1987 survey
do not represent a scientifically valid random sample. They are
based upon responses to a questionnaire sent to selected groups
of International Examiners who responded with respect to a small
number of cases selected by them. Compared to the 1984 survey
undertaken by the Assistant Commissioner (Examination), however,
they suggest one significant trend: a substantial increase in the
use of the cost plus method with a corresponding decrease in
cases classified as either "comparable uncontrolled price" or
"other." Such a trend would probably be due to an emphasis
during the last several years on examining cases that involved
manufacturing activities in tax haven jurisdictions. See GAO,
IRS Audit Coverage , supra n. 36, at 26-29.
- 23 -
Recent Service experience has been that the starting point
for analyzing any pricing issue begins with the search for a
comparable uncontrolled transaction. For a significant number of
cases, these transactions can be found, although frequently not
without a great deal of ingenuity and persistence by the
examining agent or other Service personnel.' ' If comparable
uncontrolled prices do not exist, lEs or Service economists will
seek to locate comparable transactions based on functions
performed and risks borne by the entity at issue. This type of
an issue lends itself to resale price or cost plus, depending
upon the circumstances. If neither comparable uncontrolled
prices nor comparable uncontrolled transactions can be found, a
variety of fourth methods may be used.
One justification given for the current priority of methods
in the regulations is that both the taxpayer and the Service are
thus directed to a common frame of analysis to avoid the problem
of the Service using one method while the taxpayer uses another
method. However, as currently structured, the regulations
literally require that both the taxpayer and the agent attempt to
apply the methods in priority order. Because the resale price
method generally applies only to distributors of goods, while the
cost plus method applies generally to manufacturers, there does
not seem to be any reason in theory why the agent or taxpayer
should attempt to apply the resale price method! before applying
the cost plus method.'® In practice, taxpayers and agents rely
upon comparable uncontrolled prices or transactions, when they
exist. When they do not exist, agents or taxpayers use whatever
method they believe best reflects the economic realities of the
transaction at issue. While there are valid theoretical reasons
for retaining the priority of the comparable uncontrolled price
method," there do not seem to be any valid reasons for
preferring resale price over cost plus or another method, or for
preferring resale price or cost plus over some other economically
sound method. Rather, the method used should generally be the
one for which the best data is available and for which the fewest
number of adjustments are required.
6 7
Appendix B, infra, at Questions 62-64
" In Lilly , supra n. 57, the IRS notice of deficiency was
based upon the cost plus method while the taxpayer initially
attempted to rely upon the resale price method. The Tax Court
rejected application of the cost plus method and, also, the
taxpayer's analysis under both the resale price and "fourth"
methods. It ultimately adopted a profit split method for the
first two years at issue and a CUP method for the final year.
See discussion of Lilly infra Chapters 4 and 5.
6 9
See discussion of this issue infra Chapter 11.
- 24 -
One technique that is missing from the section 482
regulations that in practice is used extensively by the
international examiners is functional analysis. This analysis
focuses on the economic functions performed by the affiliated
parties to a transaction and the economic risks borne by each of
the parties. ^° This technique is used by lEs and Service
economists not as a method standing alone but rather as a means
of verifying that prices or transactions are truly comparable to
the situation under examination or as a basis for a fourth
method.
As discussed in section B, intangibles are often transferred
by incorporation into tangible property that is sold, and setting
a transfer price for a product in such a case involves the same
difficult exercise as setting a royalty rate for a licensed
intangible. The difficulty of valuing intangibles is, therefore,
as much a problem in the context of sales of property as in the
case of licenses or other transfers of intangibles.
D. Use of Specialists and Counsel
The use of counsel and economic specialists at the
examination level would ameliorate some of the problems,
discussed above, of obtaining information and dealing with
difficult intangible pricing cases. Legal assistance during
examination is needed to assist in obtaining relevant information
and in determining whether an appropriate legal basis exists for
a proposed adjustment. Economists are needed in many cases to
perform a functional analysis and to help evaluate the proper
returns to be accorded to the related parties. Other experts
may be required to analyze practices within the taxpayer ' s
industry. The goal of the attorney, the economist, and other
specialists should be to assist the IE in obtaining all relevant
facts and to determine whether an adjustment may be sustained on
appropriate legal and economic theories if the matter ever
results in litigation.
For section 482 cases developed 10 years ago, it would have
been normal for the IE to develop the case without the assistance
of an economist or without the assistance of a Chief Counsel
attorney. Authority and expertise in international tax matters
were then split between the National Office Examination function
and the Director, Foreign Operations District. Legal expertise
in international tax matters was diffused among at least four
national office divisions and was limited in field offices.
^° I.R.M. §4233(523.2). The Manual states that almost all
cases can be analyzed using a functional analysis.
- 25 -
In May 1986 the Office of the Assistant Commissioner
(International) was created to provide an emphasis upon, and a
focal point for, development of international issues at the
examination stage. The Office of Associate Chief Counsel
(International) was created in March 1986 to provide a similar
focal point for legal issues. In addition, a network of
International Special Trial Attorneys and senior District Counsel
attorneys has been created to litigate significant international
tax cases, including section 482 cases. More importantly, these
field attorneys and their National Office counterparts have been
encouraged to assist the field in developing these cases, and
lEs are encouraged to use their assistance.^ ^
Within the last several years, the Service has substantially
increased the number of economists available to assist lEs and
has decentralized those activities from the national office to
three key District offices: Baltimore, New York, and Chicago.
Use of economists in major section 482 examinations that do not
involve safe harbors is now required.^ ^
One criticism that has been made concerning the more
extensive use of counsel and experts at the examination stage is
that the time necessary to complete an examination (already
lengthy) will be further extended. Service experience has been,
however, that increased use of specialists has not unduly delayed
disposition of the examination in the vast majority of the
cases. ^^ Furthermore, the early use of specialists in some cases
will prevent erroneous adjustments from ever being made, thus
saving both taxpayers and the government substantial sums of time
and money.
E. Conclusions & Recommendations
Access to pricing information
1. The failure of the taxpayer to document the methodology
used to establish transfer prices under the section
482 regulations and delays or failure by taxpayers in
supplying information to lEs are significant problems
that hamper the IRS in its administration of section
482.
2. The section 482 regulations are deficient in not
requiring taxpayers to document intercompany pricing
policies and to supply information upon examination.
^1 I.R.M. §4233(524).
^2 I.R.M. §42(12)3.
'3 Appendix B, infra , at Question 32
- 26 -
The section 482 regulations should be amended to
require taxpayers to document the methodology used to
establish transfer prices prior to filing the tax
return and to provide such documentation during
examination within a reasonable time after request.
The documentation should include references to any
comparable prices or transactions, rates of return,
profit splits or other information or analysis used by
the taxpayer in arriving at the transfer price.
3. Forms 5471 and 5472 should be revised to include: (a)
summary information describing how intercompany prices
were determined; and (b) an attestation that the
documentation described in paragraph 2, supra , was
available at the time of preparation of the return and
will be made available at the start of an IRS
examination .
4. lEs experiencing difficulties in obtaining transfer
pricing information have failed to deal with non-
compliant taxpayers through the issuance of section
982 requests and administrative summonses. The Service
should more aggressively pursue noncompliant taxpayers
that delay, without justification, in producing
relevant pricing information by using the section 982
and administrative summons procedures.
5. The assertion of appropriate penalties is a necessary
but often ignored element of transfer pricing
compliance. In conjunction with the Service's broad-
based review of penalties, the Government should
determine whether existing penalties are sufficient to:
( a ) compel taxpayers to provide thorough and accurate
information as set forth in paragraphs 2 and 3 supra ;
and (b) deter taxpayers from setting overly aggressive
and unjustified transfer prices that are inconsistent
with the commensurate with income standard. If it is
felt that existing penalties are inadequate,
legislative solutions should be pursued. The Service
and Treasury encourage comments in this area, including
the type of penalty, such as a transaction based
penalty, that might be proposed.
Intangibles
Establishing appropriate transfer prices for
intangibles has been a significant problem because of
the Inherent difficulty of valuing Intangibles —
particularly when Intangibles are transferred
simultaneously with the transfer of tangible property
or the provision of services.
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7. The intangibles section of the section 482 regulations
should be modified to provide a specific method of
analysis to be used when comparable uncontrolled
transactions do not exist. This method should provide
for appropriate allocation when multiple intangibles
(such as marketing and manufacturing intangibles) are
present in the same set of transactions. Part III is
devoted to the subject of an appropriate methodology •
for allocating intangible income.
Application of pricing method for transfers of tangible property
8. The current priority for the comparable uncontrolled
price method should be retained, since such prices
generally provide the best evidence of what unrelated
parties would do in an arm's length transaction. There
does not appear to be any reason to retain the current
priority of the resale price method over the cost plus
method, or for preferring resale price or cost plus
over some other economically sound method. Rather, the
method used should generally be the one for which the
best data is available and for which the fewest number
of adjustments are required.
9. Since intangibles are often incorporated into tangible
property that is sold, the difficulty of valuing
intangibles is as much of a problem in many transfers
of tangible property as in the context of licenses or
other transfers of intangible property.
Use of specialists and counsel
10. The use of counsel and economic specialists at the
examination level would ameliorate the problems of
obtaining information and dealing with the difficult
intangible pricing cases. Chief Counsel attorneys
familiar with transfer pricing issues should be
involved in significant cases at an early stage to
make sure that relevant information necessary for the
examination is being obtained and that a technical
basis for a potential adjustment exists. An economist
needs to be involved at an early stage to perform a
functional analysis and to evaluate the proper returns
to be accorded to the related parties. The goal of the
attorney, the economist, and other specialists should
be to assist the IE in obtaining all relevant facts and
to determine whether an adjustment may be sustained on
appropriate legal and economic theories if the matter
ever results in litigation.
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Chapter 4
THE SEARCH FOR COMPARABLES
A. Introduction
As explained in Chapter 2, the section 482 regulations rely
heavily on finding comparable goods, services, and intangibles to
determine whether an arm's length price has been used. Where
such comparables exist -- where arm's length transactions bearing
a reasonable economic resemblance to those being examined have
occurred in the free market — application of the regulations is
relatively straightforward. Where no comparables can be found,
or where similar items are only distantly comparable, the
regulations leave the Service, the taxpayers, and the courts with
little guidance.
This chapter examines several recent cases decided under
section 482 to assess the use of comparables by the parties and
the courts, whether in the context of either sales of tangible
property, the provision of services, or licenses or other
transfers of intangible property. These cases show that
comparables are often difficult to locate, and may be misused or
misinterpreted even if they are found. In most of the cases
discussed in this chapter, no comparables were available. The
courts' resolution of the issues in the absence of comparables is
discussed in Chapter 5.
B. Specific comparables
In recent years, transfer pricing cases involving highly
profitable products ■ — which usually are associated with unique
intangibles -- have severely tested the comparables approach of
the present section 482 regulations. This problem is illustrated
by the Lilly ^ ^ case. In Lilly , the U.S. parent corporation,
Lilly U.S., transferred highly profitable manufacturing
intangibles, including patents and know-how (primarily relating
to the drugs Darvon and Darvon-N), to its newly- formed U.S.
subsidiary in Puerto Rico, Lilly P.R., in a tax-free exchange
for Lilly P.R. stock under section 351. The Service took the
position that the income associated with those intangibles should
be allocated to Lilly U.S., notwithstanding their tax-free
transfer to Lilly P.R.
In preparation for trial , the government ' s experts surveyed
the most successful U.S. pharmaceutical products. They
discovered that the patents to such products were rarely
transferred, except to a related party. The government argued
that unrelated parties would not have transferred the Darvon
7 7
Supra n. 57,
- 29 -
intangibles and that, accordingly, there were no comparable
marketplace transactions. While the Tax Court did not fully
subscribe to the government's theory of the case, it
nevertheless was not able to find appropriate comparables for the
patented products in question for the first 2 years at issue,
1971 and 1972.''^ The court proceeded to make its own
allocations, basing its adjustments on the proposition that a
distortion of income was created by the transfer of intangibles
from Lilly U.S. to Lilly P.R. in exchange for Lilly P.R. stock.
In the Tax Court's view, the distortion arose because it felt
that Lilly would have demanded a stream of income from the
transferred Darvon intangibles in order to fund a proportionate
part of its ongoing general research and development efforts.
The Tax Court also used a profit split approach to increase the
return of Lilly U.S. on marketing expenditures and intangibles.^'
On appeal, the Seventh Circuit rejected the Tax Court's
allocation to support research and development, but affirmed its
profit split methodology.
In Searle , ° ° the petitioner transferred the patents (or
licenses) on its most successful pharmaceutical products to its
U.S. subsidiary, SCO, operating in Puerto Rico. These
intangibles represented products accounting for approximately 80
percent of the petitioner's profits and sales. As in Lilly , the
government argued that a section 482 allocation from SCO to the
petitioner was appropriate.
The petitioner, relying on section 1.482-2(d) ( 2)( ii) of the
regulations, argued that, since it had originally acquired two of
the transferred intangibles by licensing agreements carrying
royalties of ten percent and eight percent of net sales, an
unrelated party would not have paid more than a royalty in this
range for the intangible property transferred to SCO. The court,
however, found that the original licenses were not comparable;
the products were licensed from European pharmaceutical firms
prior to their approval by the FDA, and thus could not have been
marketed in the United States at the time of the license. The
^® For 1973, the Tax Court was able to use a comparable
uncontrolled price approach because the Darvon patent had
expired. However, numerous adjustments were made to reach a
transfer price.
^' See discussion of the Tax Court's profit split analysis
infra Chapter 5.
e
Supra n. 59.
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court concluded that the intangibles to SCO were significantly
more valuable than the "mere licensing agreements" upon which the
taxpayer relied.*^
Ultimately, the court found, despite the voluminous record,
that "there is little hard evidence from which we can determine
what consideration petitioner would have demanded had the
transactions under scrutiny here taken place between unrelated
parties dealing at arm's length. "'^
Problems with finding or applying comparables for valuable
intangibles have not been limited to pharmaceutical companies.
In Hospital Corporation of America , °^ a U.S. hospital management
company, HCA, entered into negotiations to recruit professional
and non-professional staff to manage a state-of-the-art hospital
in Saudi Arabia. It formed a Cayman Islands corporation, LTD,
ostensibly to negotiate and perform the management contract. HCA
performed services for LTD and made available at little cost all
of its know-how, experience, management systems knowledge, and
other intangibles. The parties offered no evidence of comparable
transactions, and the court identified none. Nevertheless, the
court allocated 25% of the Income to LTD as compensation for its
management service.
The Tax Court was also unable to find appropriate
comparables in Ciba-Geigy Corp. v. Comm'r. ,"^ where the Service
sought to reduce royalties paid by a U.S. subsidiary to its
foreign parent for the rights to manufacture and sell a
herbicide. Unlike the approach taken by the courts in Lilly for
1973, where multiple adjustments were made to a third party
transaction in order to determine a comparable price, the court
in Ciba-Geigy rejected as comparables licenses of the same
product to unrelated parties because of differences in geographic
markets, years of the license, and differences In required
purchases of raw materials.®^ Instead the court relied upon
testimony from an unrelated party about what his company would
have been willing to pay in the form of a royalty for the same
rights.
The comparability of third party resale price margins was
at issue in E.I. DuPont de Nemours & Co. v. United States
81 Id. at 375.
82 Id. at 376.
8 ^ Supra n. 17.
^* 85 T.C. 172 (1985),
85 Id. at 225-26.
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[DuPont].®^ In that case, the U.S. parent company incorporated
DuPont International S.A., DISA, in Switzerland to serve as a
super distributor of DuPont products in Europe. Internal DuPont
memos indicated that DuPont planned to sell its goods to DISA at
prices below fair market value, so that on resale most of the
profits would be reported in a foreign country having much lower
tax rates than the United States.*' Although for many products
DISA performed no special services for either DuPont or its
customers, DuPont structured its pricing to DISA anticipating
that the latter would capture 75 percent of the total profits
involved, although DISA actually realized less than this
percentage. The Service reallocated much of this profit back to
the parent.
The government introduced expert testimony at trial to the
effect that, after the allocations, DISA's ratio of gross income
to total operating costs was greater than that achieved by 32
specific firms that were functionally similar to DISA.
Additionally, it was shown that, after the allocations, DISA's
return on capital was greater than that of 96 percent of 1133
companies surveyed.*®
The taxpayer, on the other hand, relied solely upon the
resale price method. It contended that similar companies selling
similar products experienced average markups of between 19.5 and
38 percent, comparing favorably with DISA's 26 percent gross
profit margin. In rejecting the taxpayer's position the court
made the following comments:
Taxpayer tells us that a group of 21 distributors,
whose general functions were similar to DISA's,
provides the proper base of comparison. Beyond the
most general showing that this group, like DISA,
distributed manufactured goods, there is nothing in the
record showing the degree of similarity called for by
the regulation. No data exist to establish similarity
of products (with associated marketing costs),
comparability of functions, or parallel geographic (and
economic) market conditions. Rather, the record
suggests significant differences. Defendant has
■' 608 F.2d 445 (Ct. CI. 1979).
" The facts in DuPont are similar to the abuse relating
to the use of foreign base sales companies to defer the taxation
of income in the United States that Congress sought to end
through the Subpart F provisions enacted in the Revenue Act of
1962. H.R. Rep. No. 1447, 87th Cong., 2d Sess. 28 (1962).
** See discussion infra Chapter 5 regarding the income to
costs ratio and return on capital methods used in DuPont .
- 32 -
introduced evidence that the six companies plaintiff
identifies most closely with DISA all had average
selling costs much higher than DISA. Because we agree
with the trial judge and defendant's expert that, in
general, what a business spends to provide services is
a reasonable indication of the magnitude of those
services, and because plaintiff has not rebutted that
normal presumption in this case, we cannot view these
six companies as having made resales similar to DISA's.
They may have made gross profits comparable to DISA's
but their selling costs, reflecting the greater scale
of their services or efforts, were much higher in each
instance. Moreover, the record shows that these
companies dealt with quite different products
(electronic and photographic equipment) and functioned
in different markets (primarily the United States).*'
Another case that raised questions of comparability is
United States Steel v. Comm'r .'° There, the Service contended
that Navios, the petitioner's wholly owned shipping company, was
charging the petitioner more than an arm's length rate for
shipping ore from Venezuela to United States ports. The
government relied on evidence that, had U.S. Steel contracted
with other shippers for the same tonnage per year, it would have
paid considerably lower rates. The petitioner countered that,
because Navios charged unrelated steel producers the same rate as
the petitioner, a perfect comparable was available from which to
determine an arm's length price. The government contended that
the unrelated third party transactions were not comparable
because they were few in number, they were not based on a
continuing long-term relationship, and the volume shipped was
much smaller than the ten million tons annually shipped by Navios
for U.S. Steel.
The Tax Court did not decide the case on the basis of
comparables. Instead, the court focused on constructed freight
charges and on the profit that the tax haven subsidiary was
projected by the taxpayer to earn on the activities it undertook.
On appeal, the Second Circuit held that, if appropriate
comparables were available to support the petitioner's prices, no
section 482 allocation would be sustained despite evidence
tending to show that the activities resulted in a shifting of tax
liability among controlled taxpayers.'^ The appellate court
*' Supra n. 86.
'° 617 F.2d 942 (2d Cir. 1980), rev'q T.C. Memo. 1977-140.
'1 617 F.2d at 951.
- 33 -
accepted the third party transactions as comparables and reversed
the Tax Court on this issue, notwithstanding the substantial
economic differences from the related party transactions.
C. Industry Statistics as Comparables
The Service and taxpayers have relied on industry statistics
in several cases to justify or defend against section 482
allocations. Industry statistics have generally been offered as
evidence of comparable uncontrolled prices or for markup
percentages under the resale price or cost plus methods. The
courts, however, have been reluctant to accept such statistics in
the absence of a specific showing of comparability.
In the DuPont case, discussed supra , the taxpayer relied on
gross profit margins of drug and chemical wholesalers contained
in the Internal Revenue Service's Source Book of Statistics of
Income for 1960 to support a gross profit margin of 26 percent.
The gross profit margins of these companies averaged 21 percent
and ranged from 9 to 33 percent. The court noted that in
applying the resale price method it was necessary to find
substantially comparable uncontrolled resellers. Because there
was no indication from the Source Book that the necessary degree
of comparability was present, the court rejected the taxpayer's
industry statistics.
The government relied upon the Source Book of Statistics of
Income in PPG Industries Inc. v. Comm'r ,^^ to allocate a
substantial portion of the income of a Swiss corporation to its
U.S. parent. Rejecting this approach, the court found the Source
Book evidence wanting because it could not be determined whether
comparable transactions were involved.
In Ross Glove Co. v. Comm'r ,^^ the Service allocated income
from a foreign glove manufacturer to its U.S. parent. The
government relied upon expert testimony that the glove
manufacturing industry was not a high profit industry, and that
a typical glove manufacturer rarely had a year in which gross
profits equalled three percent of sales. The court rejected this
testimony because it did not relate to the rate of return earned
by Philippine glove manufacturers, such as the taxpayer's
subsidiary, whose profits generally were higher than those of
'2 55 T.C. 928 (1970).
'3 60 T.C. 569 (1973).
- 34 -
U.S. manufacturers. Industry statistics were also rejected as
unreliable in Edwards v. Conun'r ^* and in Nissho Iwai American
Corp . V . Comm ' r . ^ ^
D. The Regulations in the Absence of Comparables
The only detailed transfer pricing methods in the
regulations rely in one way or another on comparables. The cases
discussed in this chapter, in which comparables were generally
unavailable, suggest that the regulations fail to resolve the
most significant and potentially abusive fact patterns. This
failure was noted both in the Court of Claims opinion and the
trial judge's opinion in DuPont . Trial Judge Willi, after
finding for the government, suggested that the current regulatory
structure was wholly inadequate:
At least where the sale of tangible property is
involved, the Commissioner's regulations seem to accommodate
nothing short of a "pricing method" to determine the
question of an arm's length price. Treas. Reg. §1.482-
2(3 )(e)( 1 )(iii ) . Moreover, as plaintiff has correctly
noted, the regulation approach seems to rule out net profit
as a relevant consideration in the determination of an arm's
length price, this despite Congress' encouragement to the
contrary, as expressed in H. R. Rep. No. 2508, 87th Cong.,
2d Sess. 18-19 (1962) (Conference Report).
As evidenced by the magnitude of the record compiled in
this case, the resolution by trial of a reallocation
controversy under section 482 can be a very burdensome,
time-consuming and obviously expensive process -- especially
if the stakes are high. A more manageable and expeditious
means of resolution should be found,"
In difficult cases for which comparable products and
transactions do not exist, the parties and the courts have been
forced to devise ad hoc methods of their own — so-called "fourth
methods" — to determine appropriate allocations of income. The
next chapter describes the methods that the courts have used to
resolve these issues.
1978)
'< 67 T.C. 224 (1976).
'5 T.C. Memo. 1985-578.
'* 78-1 USTC para. 9374, at 83,910 (Ct. CI. Trial Div,
- 35 -
E. Conclusion
The failure of the regulations to provide guidance in the
absence of comparable products and transactions has created
problems in cases involving sales of tangible property, the
provision of services, and licenses or other transfers of
intangible property. Taxpayers and the courts have been
forced to devise ad hoc "fourth methods" to resolve such
cases.
- 36 -
Chapter 5
FOURTH METHOD ANALYSIS UNDER SECTION 482
A. Introduction
Although the "other method" provision of section 1.482-
2(e)(l)(iii) (commonly known as the "fourth method") by its terms
applies only to tangible property transfer pricing cases, the
term "fourth method" has been used to describe any case resolved
by using a method not specifically described in the regulations,
typically when comparable uncontrolled transactions were
unavailable. This chapter discusses the use of the "fourth
method" approach in the decided cases, including cases involving
the sale of tangible property, the licensing or other transfer of
intangible property, and the provision of services.
B. Profit Splits
The most frequent alternative method used by the courts in
the absence of comparables is the profit split approach. Under
this approach, the court determines the total profits allocable
to the transactions at issue and simply divides them between the
related parties in some ratio deemed appropriate by the court.
The validity of the method, of course, rests on the accurate
determination of total profits and the reasonableness of the
factors used to set the profit split ratio.
An illustration of the profit split method is found in
Lilly . ^ ^ After rejecting the resale price and cost plus pricing
methods advocated by the parties because of the absence of
comparables, the Tax Court attempted to find an appropriate
fourth method under section 1.482-2(e)( 1 )(iii ) of the
regulations. The court cited a number of studies and surveys
indicating that fourth methods were used by the Service
approximately one- third of the time, and determined that a profit
split approach was permissible.'"
In adopting the profit split approach, the Tax Court relied
heavily on PPG Industries Inc. '' The court there, in considering
the allocation of income between PPG and its foreign subsidiary,
applied a profit split analysis (which produced a 55-45 profit
split in favor of PPG) to buttress the court's primary analysis
using the comparable uncontrolled price method.
9 7
Supra n. 57. See discussion of Lilly supra Chapter 4.
'" 84 T.C. at 1148-49. The results of these surveys and
studies are referenced in Chapter 3, supra .
9 9
Supra n. 92.
- 37 -
The Tax Court in Lilly also found support in Lufkin Foundry
& Machine Co. v. Coimn'r ,^°" in which it had used a profit split
method. On appeal, the Fifth Circuit rejected the Tax Court's
profit split approach because the court had not attempted to
apply the three specific pricing methods in the regulations and
because, by itself, a profit split approach was not sufficient
evidence of what parties would have done at arm's length.
However, the court in Lilly distinguished the Fifth Circuit's
reversal of the Tax Court's holding on the following grounds:
The three preferred pricing methods detailed in the
regulations are clearly inapplicable due to a lack of
comparable or similar uncontrolled transactions.
Petitioner's evidence amply demonstrates that some
fourth method not only is more appropriate, but is
inescapable . ^ ° ^
After providing for location savings,^ °^ manufacturing
profit, marketing profit, and a charge for ongoing general
research and development performed by the parent, the Tax Court
in Lilly arrived at undivided profits of $25,489,000 for 1971
and $19,277,000 for 1972.^ "^ j^ considered these amounts to be
the profits from intangibles, consisting of manufacturing
intangibles belonging to Lilly P.R. and marketing intangibles
belonging to Lilly U.S. The court rejected the taxpayer's
argument that its marketing intangibles were of little value and
assigned 45 percent of the intangible income to Lilly U.S. as a
marketing profit and 55 percent of the intangible income to
Lilly P.R. as a manufacturing profit. The court did not explain
how it arrived at the 45-55 split, other than stating that it
used its best judgment and that it bore heavily against the
1°° T.C. Memo. 1971-101, rev'd , 468 F.2d 805 (5th Cir.
1972).
i°i 84 T.C. at 1150-51.
102 "Location savings" were specifically authorized for
certain Puerto Rican affiliates by Rev. Proc. 63-10, 1963-1 C.B.
490, 494. Location savings do not otherwise automatically accrue
to an affiliate, but under the arm's length standard of section
482 are distributed as the marketplace would divide them.
i°3 84 T.C. at 1168, n. 102.
- 38 -
taxpayer because it failed to prove the arm's length prices for
Lilly P.R.'s products.^ °* On appeal, the Seventh Circuit
affirmed the Tax Court's profit split,^°5
The Searle ^ ° * case was tried by the Tax Court shortly after
Lilly . The primary facts that distinguished Searle from Lilly
were that Searle transferred nearly all of its highly profitable
manufacturing intangibles to its Puerto Rican subsidiary and that
Searle did not purchase the products produced in Puerto Rico, but
instead marketed them in the United States as an agent for its
subsidiary. While the court could not technically apply a fourth
method under the regulations governing sales of tangible property
(since there were no intercompany sales), the court nevertheless
imposed a profit split similar in result to the profit split
imposed in Lilly .
In Searle, the Tax Court did not specifically determine the
revenue that each of the parties should earn from manufacturing
and marketing or which party should bear the expenses of
research and development and administration. While suggesting
that additional royalties were due Searle for the intangibles
provided to SCO, the court stated that "whether our allocation
herein is considered an additional payment for services or for
intangibles that were not transferred or as a royalty payment for
intangibles themselves, the result is the same."^°^
A profit split approach is also contained in section 936(h)
of the Code, added by the Tax Equity and Fiscal Responsibility
Act of 1982, effective for years beginning after December 31,
1982. In general, section 936(h) authorizes a profit split
election under which the combined taxable income of the
possessions affiliate and the U.S. affiliate, with respect to
products produced in whole or in part in the possession, will be
allocated 50 percent to the possessions affiliate and 50 percent
to the U.S. affiliate. If a profit split election is made,
section 482 is not available for any further allocation.
The section 936(h) 50-50 profit split does not, however,
provide any logical support for 50-50 profit splits in cases not
falling within the narrow scope of the section. Thus, even
though the Tax Court and Congress have moved in the direction of
50-50 profit splits in some limited cases, it would appear that
profit splits should only be used in the absence of appropriate
i°* 84 T.C. at 1167.
105 See discussion supra Chapter 4.
106 Supra n. 59. See discussion of Searle supra Chapter 4.
1°' 88 T.C. at 376.
- 39 -
comparables, and then only after a careful analysis of what
functions each party has performed, what property they have
employed, and what risks they have undertaken. When one
affiliate's role in the transactions has been extremely limited,
a 50-50 profit split may not be at all appropriate.
Such a lopsided division of relevant factors occurred in
Hospital Corporation of America .^°^ The court's opinion recites
in great detail the numerous services HCA provided for LTD in
negotiating the management contract and in staffing and operating
the hospital, as well as the numerous intangibles that HCA
provided, such as its substantial experience, know-how, and
management systems. Under these circumstances it would be
extremely difficult to estimate accurately the arm's length value
for the large volume of services and intangibles made available.
It was certainly easier for the court to look at the relative
value of the functions that each party performed, so that a
profit split ratio could be developed. The court in HCA did just
that, adopting a 75-25 (75 for HCA and 25 for LTD) split of the
profits previously reported by LTD.^°' Unfortunately, there is
no discernible rationale contained in the opinion for such a
split.
Hospital Corporation of America , like Searle , was not a
transfer pricing case and therefore was not a fourth method case
under the tangibles pricing regulation. However, both of these
cases illustrate that, when highly profitable, unique intangibles
are at issue, traditional methods of valuation will often fail
because comparables are unavailable. In these circumstances a
profit split approach appears reasonable as long as it is based
on a careful functional analysis to determine each party's
economic contribution to the combined profit.
C. Rate of Return; Income to Expense Ratios
Although profit splits are being used more frequently, the
courts have used other methods as well to justify transfer
pricing adjustments. Two of these methods are illustrated by
the DuPont ^ ^ ° case.
In defending the Service's section 482 allocations, the
government used two different methods. The first method was
computing the ratio of gross income to total operating costs
(known as the "Berry ratio" because it was first used by the
Government's expert witness. Dr. Charles Berry). DISA's Berry
io» Supra n. 17. See discussion supra Chapter 4.
109 81 T.C. at 601.
110 Supra n. 86. See discussion supra Chapter 4.
- 40 -
ratio before the allocation was 281.5 percent of operating
expenses for 1959 and 397.1 percent for 1960. After the section
482 allocation, DISA's Berry ratio was 108.6 for 1959 and 179.3
for 1960. A survey of six management firms, five advertising
firms, and 21 distributors (firms which were generally
functionally similar to DISA) revealed average Berry ratios
ranging from 108.3 to 129.3. Thus, DISA's combined Berry ratio
for 1959 and 1960 before the allocation was about three times
higher than the average for the other firms. As noted by the
court, in over a hundred years of those companies' experience,
none of them had ever achieved the ratios claimed by DISA. Even
after the allocation, its Berry ratio was somewhat higher than
that of the comparable firms.^^^
The second approach, developed by Dr. Irving Plotkin, was to
compare DISA's rate of return on capital to that of 1133
companies that did not necessarily have functional similarities
to DISA, but instead reflected a comprehensive selection from
industry as a whole. Prior to the allocation, DISA had a rate of
return of 450 percent in 1959 and 147.2 percent in 1960 -- rates
higher than those of all 1133 other companies. Even after the
allocation, DISA's rate of return exceeded that of 96 percent of
the 1133 companies surveyed.^ ^^ Based on this evidence the court
sustained the Service's allocations.
While the Berry ratio and the rate of return analysis found
in DuPont are interesting, it should be kept in mind that the
court may have looked favorably on this evidence partly because
it indicated that even after the allocation DISA earned greater
profits than almost any other corporation, whether comparable or
not. These methods were not used directly to make a section 482
adjustment, but rather to support the reasonableness of the
Service's allocation.
Evidence relating to rates of return was also presented in
Lilly . ^ ^ ^ No general research and development costs for new
drugs were being charged by the parent to the subsidiary. The
Tax Court determined that a substantial adjustment should be made
to the income of the Puerto Rican subsidiary to reflect a
proportional payment by the subsidiary of the general research
and development expense of the parent.^ ^* The difference between
m Id. at 456.
113 84 T.C. at 1157, 1161.
11* The court relied upon testimony by the Service's
accounting expert. Dr. James Wheeler, to show that, if the
taxpayer had transferred the rest of its successful products to
- 41 -
the rates of return to the two entities was not, however, due
solely to the understating of the subsidiary's research and
development expense (as determined by the court), but was also
attributable to the presence of valuable intangibles that were
not properly reflected in the transfer price. A rate of return
analysis was used to identify what appeared to be excessive rates
of return on assets, so that further inquiry could be made to
determine if the returns were in fact excessive and, if so, why.
The rate of return analysis and other information contained
in the report by Dr. Wheeler was as follows:^ ^^
1971
Return on Average Employed Assets:^ ^*
Parent (consolidated return) 19.9%
Puerto Rican Subsidiary 138.4%
Adjusted Taxable Income to Net Sales:^^'
Parent (consolidated return) 16.9%
Puerto Rican Subsidiary 69.6%
Operating Expenses to Sales:
Parent (consolidated return) 41.5%
Puerto Rican Subsidiary 9.8%
1972 1973
23.
142,
8%
6%
20.4%
68.9%
39.8%
11.6%
30.4%
100.7%
24.7%
58.8%
38.9%
16.2%
Puerto Rico under terms similar to its transfer of Darvon, its
return would have been insufficient to enable it to continue
funding its R&D program, which the court characterized as the
"life-blood" of a successful pharmaceutical company. 84 T.C.
1160-1161. As noted previously in Chapter 4, supra , the Tax
Court was reversed on this issue.
at
115
84 T.C. at 1086-88, 1092-93. See Vftieeler, An Academic
Look at Transfer Pricing in a Global Economy , Tax Notes, July 4,
1988, at 91.
^^* These assets must also have been recorded on Lilly's
financial books of account; thus some intangible assets are not
included. In a recent article, it was noted that Eli Lilly had a
five year average return on shareholders equity of 23 percent (on
an after-tax basis). Who's Where in Profitability , Forbes,
January 11, 1988, at 216. Compare this consolidated return on
assets with the return in excess of 100 percent earned by the
Puerto Rican subsidiary during the years 1971-1973.
^^^ The adjusted taxable income for the subsidiary does not
reflect the exclusion provided by section 931 of the Internal
Revenue Code of 1954 and excludes interest income.
- 42 -
Computations based on the record in Searle ^^" and reflected
in the companies' income tax returns (also part of the record)
show a similar disproportion. By way of indirect comparison, in
1968 (the year before intangibles were transferred to Puerto
Rico), Searle reported taxable income of approximately
$46,700,000 on sales of approximately $81,800,000. In the years
before the Tax Court, Searle 's sales declined to approximately
$38,200,000 in 1974 and $46,700,000 in 1975, resulting in losses
of $9,800,000 in 1974 and $23,100,000 in 1975. During these
years the Puerto Rican subsidiary had net sales and income of:
Year
Net sales
Net income
1974
1975
$114,784,000
138,044,000
$74,560,000
72,240,000
The rates of return on assets based on the company ' s tax
return position were as follows:^ ^'
1974
1975
(31.2%)
109.2%
(42.3%)
119.0%
54.0%
13.3%
56.2%
13.6%
98.7%
35.4%
106.5%
35.6%
Return on Average Employed assets:
Parent (consolidated return)
Puerto Rico Subsidiary
Cost of Goods Sold to Sales:
Parent (consolidated return)
Puerto Rico Subsidiary
Operating Expenses to Sales:
Parent (consolidated return)
Puerto Rico Subsidiary
It is important to note that the data regarding rate of
return and other evidence presented by the government in Lilly
and Searle did not necessarily provide the court or the parties
with a definitive, quantitative transfer price or charge for
intangibles. Rather, like Dr. Plotkin's testimony in DuPont , it
was used to support the reasonableness of a resulting allocation
or determination.^^" As discussed in Chapter 11, the Service and
Treasury believe that. In cases where no comparables exist, a
more refined rate of return analysis can be used to establish a
transfer price and not merely to verify the reasonableness of an
allocation.
118
119
Supra n. 59.
Wheeler, supra n. 115, at 91.
^20 The Seventh Circuit in Lilly , supra n. 57, discounted
this type of evidence because it called into question Lilly
P.R.'s ownership of the intangibles at issue.
- 43 -
D. Customs Values
An additional approach to transfer pricing that has
occasionally been used in litigation is that of adopting the
values set by the United States Customs Service. For example, in
Ross Glove Co. ,^^^ the Tax Court accepted the taxpayer's use of
the markup used by Customs in valuing gloves imported from the
Philippines for purposes of applying the cost plus method.
However, in Brittingham v. Commissioner , ^ ^ ^ the Tax Court made it
clear that it would not bind taxpayers to their own declared
Customs' valuations where it could be shown that those values
were erroneous.^ ^ ^
E. Conclusions and Recommendations
1. Over the years the courts, and in particular the Tax
Court, have used various fourth methods for determining
appropriate arm's length prices for section 482
allocations. A profit split is appropriate in some
cases to establish a transfer price on an arm's length
basis because unrelated parties are concerned about the
respective shares of potential profits when entering
into a business arrangement.^^* The problem with the
profit split approach taken by the courts, however, is
not that the courts have focused on the wrong elements
of the transaction, but that they generally have
failed to adopt a consistent and predictable
methodology.
2. The rate of return on assets and costs to income ratio
methods used in DuPont provide some reasonable basis
for allocating income and determining transfer prices
in the absence of comparables. However, these methods
have not yet been sufficiently developed by the courts
to fill the gap in analysis left by the section 482
regulations when comparable uncontrolled transactions
cannot be located. A profit split or other method
121 Supra n. 93. See discussion supra Chapter 4.
^22 66 T.C. 373 (1976), aff 'd , 598 F.2d 1375 (5th Cir.
1979).
^23 Largely in response to the Brittingham case. Congress
enacted section 1059A in 1986. This section generally forces an
importer to use a value for income tax purposes no greater than
the value declared for customs purposes.
^24 See J. Baranson, Technology and the Multinationals at
64 (1978).
- 44 -
should be developed to determine transfer prices in the
absence of comparables, which is the subject of Part
III of this study.
- 45 -
II. SECTION 482 AFTER THE 1986 TAX REFORM ACT
Part I of the study described the history of section 482,
its administration by the Service, and its interpretation by the
courts. The lack of specific guidance in the tangible property,
intangible property, and services provisions of the section 482
regulations to resolve cases for which appropriate comparables do
not exist -- notably cases involving high profit intangibles —
has caused significant problems for taxpayers, the Service, and
courts alike.
The amendment made by the 1986 Act to section 482 is
Congress ' response to the problem described in Part I of
determining transfer pricing for high profit intangibles.
Specifically, section 482 was amended to provide that income from
a transfer or license of intangible property shall be
commensurate with the income attributable to the intangible.
This Part II discusses the scope of the commensurate with income
standard and the requirement for periodic adjustments. The
compatibility of these changes with the international norm for
transfer pricing -- the arm's length principle — is also
discussed. Finally, this part explores the role of safe harbors
for avoiding adjustments under section 482.
Chapter 6
THE COMMENSURATE WITH INCOME STANDARD
A. Legislative History
The 1986 Act amended section 482 to require that payments to
a related party with respect to a licensed or transferred
intangible be "commensurate with the income"^ ^* attributable to
^^* (e) Treatment of Certain Royalty Payments. —
(1) In General.-- Section 482 (relating to
allocation of income and deductions among taxpayers) is
amended by adding at the end thereof the following new
sentence: "In the case of any transfer (or license) of
intangible property (within the meaning of section
936(h)(3)(B)), the income with respect to such transfer
or license shall be commensurate with the income
attributable to the intangible."
(2) Technical Amendment.-- Subparagraph (A) of
section 367(d)(2) (relating to transfers of intangibles
treated as transfer pursuant to sale for contingent
payments) is amended by adding at the end thereof the
following new sentence: "The amounts taken into
account under clause (ii) shall be commensurate with
- 46 -
the intangible. The provision applies to both manufacturing and
marketing intangibles.^ ^ ^ The legislative history clearly
indicates Congressional concern that the arm's length standard as
interpreted in case law has failed to allocate to U.S. related
parties appropriate amounts of income derived from
intangibles.^ ^^ The amendment is a clarification of prior law.
Accordingly, it should not be assumed that the Service will cease
taking positions that it may have taken under prior law.
The primary difficulty addressed by the legislation was the
selective transfer of high profit intangibles to tax havens.
Because these intangibles are so often unique and are typically
not licensed to unrelated parties, it is difficult, if not
impossible, to find comparables from which an arm's length
the income attributable to the intangible."
Sec. 1231(e)(1), Tax Reform Act of 1986, 100 Stat. 2085 (1986).
125 pqj. this purpose, intangibles are broadly defined by
reference to section 936(h)(3)(B) under which intangible property
includes any:
(i) patent, invention, formula, process, design,
pattern, or know-how;
(ii) copyright, literary, musical, or artistic
composition;
(iii) trademark, trade name, or brand name;
(iv) franchise, license, or contract;
(v) method, program, system, procedure, campaign,
survey, study, forecast, estimate, customer list, or
technical data; or
(vi) any similar item,
which has substantial value independent of the services of any
individual. See also Treas. Reg. §1 .482-2( d) (3 )( ii ) and Rev.
Rul. 64-56, 1964-1 C.B. 113, regarding the treatment of know-how
as property in a section 351 transfer.
126 1985 House Rep., supra n. 47, at 420-427; 1986 Conf.
Rep., supra n. 2, at 11-637-638. Several commentators have
suggested that the phrase "commensurate with income" derives from
Nestle Co., Inc. v. Comm'r , T.C. Memo. 1963-14, where the Tax
Court sanctioned a taxpayer's post-agreement increase in
royalties paid by an affiliate for a very profitable intangible
license. The opinion states that "[s]o long as the amount of the
royalty paid was commensurate with the value of the benefits
received and was reasonable , we would not be inclined to, nor do
we think we would be Justified to, conclude that the increased
royalty was something other than what it purported to be."
(Emphasis supplied). There is, however, nothing in the
legislative record to indicate that this is the case or to
indicate Congressional approval or disapproval of the result in Nest
- 47 -
transfer price can be derived. When Justifying the compensation
paid for such intangibles, however, taxpayers often used
comparisons with industry averages, looked solely at the
purportedly limited facts known at the time of the transfer, or
did not consider the potential profitability of the transferred
intangible (as demonstrated by post-agreement results).
Taxpayers relied on intangibles used in vastly different product
and geographic markets, compared short-term and long-term
contracts, and drew analogies to transfers where the parties
performed entirely different functions in deriving income from
the intangible.
Congress determined that the existing regime, which depends
heavily upon the use of comparables and provides little clear
guidance in the absence of comparables, was not in all cases
achieving the statutory goal of reflecting the true taxable
income of related parties. Congress therefore decided that a
refocused approach was necessary in the absence of tnae
comparables. The amount of income derived from a transferred
intangible should be the starting point of a section 482
analysis and should be given primary weight.^ ^' Further, it is
important to analyze the functions performed, and the economic
costs and risks assumed by each party to the transaction, so that
the allocation of income from the use of the intangible will be
made in accordance with the relative economic contributions and
risk taking of the parties.^ ^' The application of the functional
analysis approach to the actual profit experience from the
exploitation of the intangible allocates to the parties profits
that are commensurate with intangible income. Looking at the
income related to the intangible and splitting it according to
relative economic contributions is consistent with what
unrelated parties do. The general goal of the commensurate with
income standard is, therefore, to ensure that each party earns
the income or return from the intangible that an unrelated party
would earn in an arm's length transfer of the intangible.
In determining the income that forms the basis for
application of the commensurate with income standard, what time
frame should be used as a point of reference: the time of the
transfer alone, or an annual or other periodic basis? The
legislative history reflects Congressional concern that, by
confining an analysis of an appropriate transfer price to the ,
time a transfer was made, taxpayers could transfer a high profit
potential intangible at an early stage and attempt to justify use
of an inappropriate royalty rate by claiming that they did not
^27 1985 House Rep., supra n. 47, at 426.
128 1986 Conf. Rep., supra n. 2, at 11-637,
- 48 -
know that the product would become successful.^ ^ ' Accordingly,
for these reasons. Congress determined that the actual profit
experience should be used in determining the appropriate
compensation for the intangible and that periodic adjustments
should be made to the compensation to reflect substantial changes
in intangible income as well as changes in the economic
activities performed and economic costs and risks borne by the
related parties in exploiting the intangibles.^ -^ ° As discussed
further below, this is consistent with what unrelated parties
would do.
The legislative history indicates that the commensurate with
income standard does not prescribe a specific, formulary approach
for determining an intangible transfer price. For example, it
does not automatically require that the transferor of the
intangible receive all income attributable to the exploitation of
the intangible. It does not prescribe (nor depend for its
application upon) a specific legal form for transfers of
intangible property. Thus, it applies to licenses of intangible
property, sales of tangible property which incorporate valuable
intangibles, and to transfers of intangibles through the
provision of services. Nor does it mandate any specific
treatment of the transferor or transferee. In particular, the
provision does not mandate a "contract manufacturer" return for
the licensee in all cases.^^^
B. Scope of Application
The scope of the commensurate with income standard is not
discussed in the legislative history. Two proposals have been
made for limiting the scope of the standard, one based on
potential double taxation and one limiting the application of the
provision to the types of cases that prompted the legislative
change .
1. Double Taxation and Related Issues . Double taxation can
occur when two countries have different rules of allocation; have
the same rules but interpret or apply them differently in actual
operation; have the same rules and interpret and apply them in
the same way, but do not allow correlative adjustments; or
^29 1985 House Rep., supra n. 47, at 424.
^30 Id. at 425-426.
131 Id. at 426.
- 49 -
permit correlative adjustments in theory but do not remove
procedural barriers ( e.g. , statutes of limitation on refund
claims).^ 3 2
Taxpayers and others have argued that the commensurate with
income standard will necessarily increase the incidence of double
taxation, and that therefore Congressional intent should not be
fully implemented. As described more fully in the next chapter,
the correct application of the commensurate with income standard
is premised soundly on arm's length principles. The Service and
Treasury therefore do not believe that the commensurate with
income principle will increase the incidence of double taxation.
Indeed, in fairly common cases where the commensurate with
income standard will be applied -- outbound transfers of
intangibles from U.S. parents to foreign subsidiaries — the
issue of double taxation does not arise. In these situations,
the foreign tax credit provisions of U.S. domestic law (including
the foreign sourcing and characterization of royalties relating
to intangibles used overseas) will normally prevent the double
taxation of earnings.^ ■'^ Furthermore, the outbound transfer
patterns that were the subject of Congressional concern involve
transfers to manufacturing affiliates located in tax havens,
where there is no potential for double taxation. The question of
whether the appropriate amount of income is attributed to foreign
operations in these cases is, therefore, whether the correct
amount of income is eligible for deferral from U.S. tax and
whether it is properly characterized for foreign withholding tax
purposes, rather than the issue of double taxation.
2. Legislative Impetus . The commensurate with income
standard was clearly intended to overcome problems encountered in
applying the section 482 regulations to transfers of high profit
potential intangibles, such as those at issue in Lilly and
Searle . Because of its origin as a response to the problem of
^^^ International Fiscal Association, Cahiers de Droit
Fiscal International (Studies on International Fiscal Law), Vol.
LVI, at 1-6 (1971).
^^^ So long as the foreign affiliate ultimately pays out
its residual earnings as a dividend and exhausts its remedies for
obtaining an adjustment in the foreign jurisdiction, the total
amount of foreign source income on the U.S. return in the
relevant limitation category (and, therefore, the amount of
limitation under section 904) will be the same no matter what the
amount of royalty, and the taxes paid by the foreign affiliate
will be deemed paid by the U.S. parent. The operation of the
foreign tax credit will thus prevent any double taxation on those
earnings irrespective of the amount of the royalty payment for
U.S. tax purposes.
- 50 -
high profit intangibles, it has been suggested that the
commensurate with income standard should be limited to transfers
of high profit intangibles to affiliates in low tax
jurisdictions.^^* The statute, however, applies to all related
party transfers of intangibles, both inbound and outbound,^^^
without quantitative or qualitative restrictions.
Furthermore, the economic theory of arm's length dealing
underlying the methods set forth in this study apply to all
transfers of intangibles, regardless of the type of intangible or
residence of the licensee. Consequently, the commensurate with
income standard should apply to transfers of all related party
intangibles, not Just the high profit potential intangibles. The
analysis set forth in Chapter 11 provides a framework for
implementing the commensurate with income standard that can be
applied to all intangible transfers, rather than merely to high
profit potential intangibles.
C. Application of Commensurate with Income Standard
to Normal Profit and High Profit Intangibles
1. Normal Profit Intangibles . In related party transfers
of normal profit intangibles, there are likely to be comparable
third party licenses. Such licenses can produce evidence of
arm's length dealings. The arm's length bargaining of the
unrelated parties over the terms of the arrangement reflects each
party's judgment about what its share of the combined income (or
appropriate expense reimbursement) ought to be. Hence, each has
made a judgment that the remuneration it expects to receive is
commensurate with the income attributable to its exploitation of
the intangible.
Application of the commensurate with income standard to
normal profit intangibles will ordinarily produce results
consistent with those obtained under pre-1986 law in those cases
where economically appropriate comparables were used. For
example, the licensing agreement for the formula to a particular
brand of perfume is likely to have many "inexact"
comparables.^^' If appropriate comparables exist, they can be
examined to determine an arm's length, or commensurate with
income, return. Thus, in many cases the appropriate income
^^* Wright & Clowery, The Super-Royalty; A Suggested
Regulatory Approach . Tax Notes, July 27, 1987, at 429-436.
^3 5 1996 Conf, Rep., supra n. 2, at 11-637.
136 See discussion of the concepts of inexact and exact
comparables infra Chapter 11.
- 51 -
allocation under both the existing regulations and the
conunensurate with income standard will be the same, provided that
internal and external standards of comparability are met.^^'
2. High Profit Potential Intangibles . As described in
Chapter 4, the difficulty in applying section 482 to high profit
potential intangibles^ ^ ^ is that unrelated party licenses of
comparable intangibles almost never exist. Consequently, if the
appropriate related party transfer price for a high profit
potential intangible is expressed in terms of a royalty, the
result may not bear any resemblance to a third party license for
a normal intangible. That is, owing to the intangible's
enormous profitability, an allocation under the commensurate with
income standard, if made solely through a royalty rate
adjustment, might be so large compared to normal product royalty
rates that it does not look like an arm's length royalty.
Therefore, one might argue that an extraordinarily high rate
could never be an arm's length royalty merely because third
party royalties are never that high.
From an economic perspective, however, an unprecedented or
"super-royalty" rate may be required to appropriately reflect a
relatively minor economic contribution by the transferee and
achieve a proper allocation of income.^ ^' As discussed in
Chapter 11, the commensurate with income standard, in requiring a
"super-royalty" rate in order to achieve a proper allocation of
income in such a case, does not mandate a rate in excess of arm's
length rates. Nor does it permit taxpayers to set a "super-
13^ See discussion of the concepts of internal and
external comparability infra Chapter 11.
^ ^ ^ The term high profit potential intangibles refers to
those products which generate profits far beyond the normal
returns found in the industry. No specific definition or formula
for determining whether an item is a high profit potential
product is suggested herein. Nonetheless, hypothetical products
such as an AIDS vaccine, a cure for the common cold, or a cheap
substitute for gasoline would all fit into this concept because
of the enormous consumer demand for such a product, the market
protection provided by a patent, and the corresponding potential
for enormous profitability. Similarly, a patented product that
just happens to work better than others, or produces the same
result with fewer side effects, may also qualify.
^^' The German tax authorities have faced a similar
situation, and the imputation of very high royalty rates has led
to the charge that the imputed royalties are not arm's length.
See Jacob, The New "Super-Royalty" Provisions of Internal
Revenue Code 1986; A German Perspective , 27 European Taxation
320 (1987).
- 52 -
royalty" rate in excess of arm's length rates. For example,
enactment of the commensurate with income standard would not
justify royalty increases in excess of arm's length rates by
U.S. affiliates of foreign parent corporations (or vice versa).
Rather than creating a new class of royalty arrangements,
the enactment of the commensurate with income standard reflects
the recognition that, for certain classes of intangibles
(notably high profit potential intangibles for which comparables
do not exist), the use of inappropriate comparables had failed to
produce results consistent with the arm's length standard.
Enactment of the commensurate with income standard was thus a
directive to promulgate rules that would give primary weight to
the income attributable to a transferred intangible in
determining the proper division of that income among related
parties. In the rare instance in which there is a true
comparable for a high profit intangible, the royalty rate must be
set on the basis of the comparable because that remains the best
measure of how third parties would allocate intangible income.
D. Special Arrangements
1. Lump sum sales or royalties . Some commentators have
suggested that the commensurate with income standard should not
prohibit the use of non-contingent, lump sum royalty or sale
payments. While the Service and Treasury agree that parties are
free to structure their transactions as either a sale or license,
the economic consequences of a lump svxm payment arrangement
generally must resemble those under a periodic payment approach
in order to satisfy the commensurate with income standard, unless
the taxpayer can demonstrate, by clear and convincing evidence,
that such treatment is inappropriate on the basis of arm's length
arrangements, i.e. , an exact or inexact comparable
transaction.^*'' By its terms, the amendment to section 482
applies to any transfer of an intangible, which includes an
outright transfer by sale or license for a non-contingent, lump
sum amount . ^ * ^ Furthermore , exempting such arrangements from the
commensurate with income standard would elevate form over
substance and encourage non-arm's length lump sum arrangements
designed to circumvent the new rules. Thus, periodic adjustments
may be required under the commensurate with income standard even
in the case of lump sum sale or royalty arrangements.^*^
1*° See infra Chapter 11.
^*^ 1985 House Rep., supra n. 47, at 425.
^*^ See discussion of the mechanism for making adjustments
to lump sum payments infra Chapter 8 .
- 53 -
2. Interaction with Section 367(d) . Section 367(d),
enacted as part of the 1984 Tax Reform Act, provides that when
intangible property is transferred by a U.S. person to a foreign
corporation in a transaction described in section 351 or 361, the
transferor shall be treated as receiving annual payments, over
the useful life of the property, contingent on productivity or
use of the property, regardless of whether such payments are
actually made. These payments are treated as U.S. source income'.
A subsequent disposition to an unrelated party of either the
intangible property or the stock in the transferee triggers
immediate gain recognition. The 1986 Act made the commensurate
with income standard applicable in computing payments
attributable to the transferor under section 367(d). The
periodic adjustment of lump sum royalty or sale payments would
merely achieve parity with section 367(d) transfers.^ * ^ Section
367(d) may also suggest that certain exceptions from the
periodic payment approach may be appropriate -- e.g. , transfers
to corporations in which an unrelated corporation has a
substantial enough Interest that an objective valuation of the
transferred intangible can be considered to be arm's length.^**
Sales and licenses of intangibles are generally not subject
to section 367(d), since they are not transactions described in
section 351 or 361. The temporary regulations state that, when
an actual license or sale has occurred, an adjustment to the
consideration received by the transferor shall be made solely
under section 482, without reference to section 367(d).^*^
However, if the purported sale or license to the related person
is for no consideration^** or if the terms of the purported sale
or license differ so greatly from the substance of an arm's
length transfer that the transfer should be considered a sham,^*^
the transfer will be treated as falling within section 367(d).
In essence, the commensurate with income standard treats
related party transfers of Intangibles as if an intangible had
been transferred for a license payment that reflects the
^*^ Staff of Joint Comm. on Taxation, General Explanation
of the Revenue Provisions of the Deficit Reduction Act of 1984 ,
98th Cong., 2d Sess. 432-433 (1984) [hereinafter General
Explanation of the DRA of 1984 ] .
^** The Service and Treasury invite comments as to whether
this possible exception should be under a different standard than
the concept of control under section 482.
1*5 Treas. Reg. S1.367( d)-lT(g) (4 ) ( 1 ) .
^*^ Id.
1*' Treas. Reg. §1.367(d)-lT(g) (4 ) ( 11 ) .
- 54 -
intangible's value throughout its useful life, a result similar
to section 367(d). Because the section 367(d) source of income
rule can apply to certain transactions cast in the form of a sale
or license, the temporary regulations could be amended to specify
which sales or licenses are subject to both the commensurate with
income standard and the UoS. source income characterization of
section 367(d). Moreover, a license payment that is less than
some specific percentage of the appropriate arm's length amount
could be considered so devoid of economic substance that the
arm's length charge should be subject to section 367(d). Thus,
those related party transfers which deviate substantially from
the proper commensurate with income payment would be subject to
367(d), even if cast in the form of a sale or license.
3. Cost sharing agreements . The legislative history
envisions the use of bona fide research and development cost
sharing arrangements as an appropriate method of attributing the
ownership of intangibles ab initio to the user of the intangible,
thus avoiding section 482 transfer pricing issues related to the
licensing or other transfer of intangibles.^*^ Use of cost
sharing arrangements had previously been encouraged in
connection with the enactment in 1984 of section 367 (d).^*' Cost
sharing arrangements are discussed in detail in Chapters 12 and
13, infra .
E. Conclusions
1.. Congress enacted the commensurate with income standard
because application of existing rules had not focused
appropriate attention upon the income generated by the
transfer of an intangible in situations in which
comparables do not exist.
2. Application of the commensurate with income standard
requires the determination of the income from a
transferred intangible, and a functional analysis of
the economic activities performed and the economic
costs and risks borne by the related parties in
exploiting the intangible, so that the intangible
income can be allocated on the basis of the relative
economic contributions of the related parties. The
commensurate with income standard does not mandate a
"contract manufacturer" return for the licensee in all
or even most cases.
^** 1986 Conf. Rep., supra n. 2, at 11-638.
^*' General Explanation of the DRA of 1984 , supra n. 143,
at 433,
- 55 -
3. The commensurate with income standard requires that
intangible income be redetermined and reallocated
periodically to reflect substantial changes in
intangible income, or changes in the economic
activities performed and economic costs and risks
borne by the related parties.
4. The application of the functional analysis approach to
the actual profit experience from the exploitation of
intangibles is consistent with what unrelated parties
would do and is, therefore, consistent with the arm's
length principle.
5. Because the commensurate with income standard is
consistent with arm's length principles, it should not
increase the incidence of double taxation.
6. The commensurate with income standard applies to all
types of intangible property transfers between related
parties, not just high profit potential intangibles,
including both inbound and outbound transfers of
intangibles. In the cases of normal profit intangibles
in which comparables normally exist, the new standard,
like prior law, will ordinarily base the analysis on
comparable transactions, with refinements in the
definition of appropriate comparables. In any event,
intangible income must be allocated on the basis of
comparable transactions if comparables exist.
7. Lump sum sale and royalty payments for intangibles
generally will be subject to the commensurate with
income standard.
- 56 -
Chapter 7
COMPATIBILITY WITH INTERNATIONAL TRANSFER PRICING STANDARDS
A. Introduction
Shortly after passage of the 1986 Act, various U.S.
taxpayers and representatives of foreign governments expressed
concern that the enactment of the commensurate with income
standard was inconsistent with the "arm's length" standard as
embodied in tax treaties and adopted by many countries for
transfer pricing matters. As a result, they argued, the
application of the commensurate with income standard would lead
to double taxation for which no remedy would exist under
treaties, because of application of transfer pricing standards by
the United States that would be inconsistent with those applied
by various other foreign governments . ^ ^ °
To allay fears that Congress intended the commensurate with
income standard to be implemented in a manner inconsistent with
international transfer pricing norms and U.S. treaty obligations.
Treasury officials publicly stated that Congress intended no
departure from the arm's length standard, and that the Treasury
Department would so interpret the new law.^^^ Treasury and the
Service continue to adhere to that view, and believe that what is
proposed in this study is consistent with that view.
B. The Arm's Length Standard as an International Norm
The problem of double taxation arising from different
transfer pricing methods has been addressed through
intergovernmental negotiation and agreement, principally in
bilateral tax treaties that specifically provide for certain
adjustments by the treaty partners to the tax liability of any
entity when its dealings with related entitles differ from those
that would have occurred between unrelated parties. For example,
an OECD model income tax convention permits adjustments to the
150 See discussion supra Chapter 6 regarding relief from
double taxation pursuant to the foreign tax credit provisions and
sourcing rules of United States Internal law.
^^^ Letter from J. Roger Mentz, Assistant Secretary (Tax
Policy) of the Department of Treasury to Representative Philip M.
Crane (May 26, 1987); Remarks of Stephen E. Shay, International
Tax Counsel of the Department of Treasury before the
International Fiscal Association (February 12, 1987). Appendix C
to this study summarizes the legal and administrative approaches
similar to those described throughout this study taken by some of
our major treaty partners in dealing with transfer pricing
issues.
- 57 -
profits of an enterprise where, in dealing with related
enterprises, "conditions are made or imposed between the two
enterprises in their commercial or financial relations which
differ from those which would be made between independent
enterprises. ... "^ ^ ^ If the adjustment is consistent with that
standard, the OECD Model Convention calls for the other
contracting state to make an adjustment to the profits of the
enterprise in its jurisdiction to take into account the first
state's adjustments.^ ^ ^ If differences of opinion arise between
the two states as to the proper application of this standard, the
OECD Model Convention calls for the competent authorities of the
respective jurisdictions to consult with one another.^ ^* The
other major model used by countries in negotiating their tax
treaties, the United Nations Model Double Taxation Convention
Between Developed and Developing Countries, contains an Article 9
entitled "Associated Enterprises" that is not materially
different.^ 5 5
In 1981, the Treasury Department released a model income tax
treaty that it uses as a starting point for negotiating income
tax treaties with other countries.^ ^* Although this model has
been revised in a number of particulars to account for the many
changes in U.S. tax law since the time of its release, the
provisions governing associated enterprises have not changed.
The basic provision is virtually identical to the OECD Model
Convention . ^ ^ ^
^^2 Organization of Economic Cooperation and Development,
Committee on Fiscal Affairs, Model Double Taxation Convention on
Income and on Capital , Art. 9(1) ("Associated Enterprises")
(1977) [hereinafter OECD Model Convention].
153 Id. at Art. 9(2).
154 Id.
15 5 United Nations Model Double Taxation Convention Between
Developed and Developing Countries , U.N. Doc. ST/ESA/102, at 27
(1980) [hereinafter U.N. Model Convention].
156 U.S. Treasury Dept., Proposed Model Convention Between
the United States of America and .... for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income and Capital (1981).
157 The United States model adds a third paragraph to the
OECD Model Convention Article 9 that reserves to each state the
right to make adjustments under its internal law. The purpose of
this paragraph is only to make explicit that the use of the word
"profits" in the OECD model does not constrain either
jurisdiction to make adjustments, consistent with the arm's
- 58 -
The arm's length standard is embodied in all U.S. tax
treaties; it is in each major model treaty, including the U.S.
Model Convention; it is incorporated into most tax treaties to
which the United States is not a party; it has been explicitly
adopted by international organizations that have addressed
themselves to transfer pricing issues;^ ^® and virtually every
major industrial nation takes the arm's length standard as its
frame of reference in transfer pricing cases.^^' This
overwhelming evidence indicates that there in fact is an
international norm for making transfer pricing adjustments and
that the norm is the arm's length standard.^ ^°
It is equally clear as a policy matter that, in the interest
of avoiding extreme positions by other jurisdictions and
minimizing the incidence of disputes over primary taxing
jurisdiction in international transactions, the United States
should continue to adhere to the arm's length standards
length standard of paragraph 1, with respect to deductions,
credits, or other allowances between related persons. This
provision reads as follows:
3. The provisions of paragraph 1 shall not limit any
provisions of the law of either Contracting State which
permit the distribution, apportionment or allocation of
income, deductions, credits, or allowances between persons,
whether or not residents of a Contracting State, owned or
controlled directly or indirectly by the same interests when
necessary in order to prevent evasions of taxes or clearly
to reflect the income of any of such persons. Id.
^^® U.N. Model Convention, supra n. 155, at 106; see
generally Organization for Economic Cooperation and Development,
Report of the Committee on Fiscal Affairs, Transfer Pricing and
Multinational Enterprises (1979) [hereinafter OECD, Transfer
Pricing and Multinational Enterprises ] .
159 See , e.g. , Cross-Border Transactions Between Related
Companies: A Summary of Tax Rules (W. R. Lawlor, ed. 1985)
(discussion of transfer pricing practices of twenty-five
different countries, most of which take the arm's length
standard as their basic rule of transfer pricing).
^^° A recent article has suggested that the arm's length
standard for transfer pricing should not limit the transfer
pricing practices of governments. Langbein, The Unitary Method
and the Myth of Arm's Length , Tax Notes, Feb. 17, 1986, at 625.
- 59 -
C. Reference to Profitability under the Arm's Length Standard
Because the arm's length standard Is the International norm,
a serious potential for disputes over primary taxing Jurisdiction
would exist if the United States were to Implement the
commensurate with income standard in a manner that violates arm's
length principles. Does a system which, only in the absence of
appropriate comparable transactions, places primary emphasis upon
the Income (or profits) related parties earn from exploiting an
intangible violate the arm's length standard, as understood in
the international context?
Probably the most commonly referenced expression of the
arm's length standard as understood by the nations that have
adopted it is a report issued in 1979 by the OECD.^*^ This
report adopts the general principle of arm's length pricing for
all transactions between related parties. Concerning transfers
of intangible property, the report states:
The general principle to be taken as the basis for the
evaluation for tax purposes of transfer prices between
associated enterprises under contracts for licensing patents
or know-how is that the prices should be those which would
be paid between independent enterprises acting at arm's
length.^ '2
It is useful to refer to those methods that the report
considers inconsistent with its arm's length concept to aid in
defining such concept. These the report refers to as "global"
methods for transfer pricing. They would include, for example,
"allocating profits in some cases in proportion to the respective
costs of the associated enterprises, sometimes in proportion to
their respective turnovers or to their respective labour forces,
or by some formula taking account of several such criteria. "^ ' ^
The report criticizes these methods as necessarily arbitrary.^'*
The report also notes that the effect of its arm's length
approach, as distinguished from those it criticizes, is:
[T]o recognise the actual transactions as the starting
point for the tax assessment and not, in other than
^*^ OECD, Transfer Pricing and Multinational Enterprises ,
supra n. 158.
16 2
16 3
Id. at 51.
Id. at 14.
1'* Id. at 14-15.
- 60 -
exceptional cases, to disregard them or substitute other
transactions for them. The aim in short is, for tax
purposes, to adjust the price for the actual transaction to
an arm's length price.^^^
Nowhere, however, does the report suggest that the profits
of the related enterprises are irrelevant to this determination.
Indeed, there are several instances where the report specifically
authorizes an inquiry into profits or profitability. For
example, the report notes:
[Its criticism of global methods] is not to say, however,
that in seeking to arrive at the arm's length price in a
range of transactions, some regard to the total profits of
the relevant [multinational enterprise] may not be helpful,
as a check on the assessment of the arm's length price or in
specific bilateral situations where other methods give rise
to serious difficulties and the two countries concerned are
able to adopt a common approach and the necessary
information can be made available.^'*
In arriving at an arm's length price, the report specifically
authorizes an analysis of economic functions performed by each
related party in determining "when a profit is likely to arise
and roughly what sort of profit it is likely to be."^"
Other references to profits occur in the report. For
example, in the section of the report relating to the sale of
tangible goods entitled "Methods of Ascertaining an Arm's Length
Price, " methods are outlined that permit reference to comparable
profits or returns on capital invested as a means of determining
the appropriate transfer price. These methods are viewed by the
report as a supplement to the traditional approach of looking to
comparable transactions, but they are clearly suggested as
appropriate tools for arriving at a proper transfer price.^^'
With regard to valuing transfers of intangible property, the
report notes that, "[o]ne of the common approaches employed in
practice is to make a pragmatic appraisal of the trend of an
enterprise's profits over a long period in comparison with those
of other unrelated parties engaged in the same or similar
^*5 Id. at 19.
1*^ Id. at 15.
1^' Id. at 17.
^*8 Id. at 42-43.
- 61 -
activities and operating in the same area."^^' The report
questions whether this approach is practical, because it would be
difficult to isolate respective profits due to different
accounting methods, and difficult to know-how to apportion the
overall profit between the two parties. No suggestion is made,
however, that such a method could never be used in the absence of
comparable transactions because it conflicts in principle with
the arm's length standard.^ ^°
D. Periodic Adjustments under the Arm's Length Standard
The next chapter describes an important element of the
commensurate with income standard -- periodic adjustments must be
made in appropriate cases to reflect actual profit experience
under the license. As noted in that chapter, there are sound
arm's length reasons to require such adjustments — principally
the rarity of long-term, fixed licenses negotiated at arm's
length, particularly with respect to high profit potential
intangibles, and the fact that actual profit experience under a
license indicates in most cases anticipated profits that would
have been considered by unrelated parties. Moreover, that
chapter permits taxpayers to avoid adjustments over time if they
can demonstrate on the basis of arm's length evidence that no
such adjustments would have been made by unrelated parties. The
Service and Treasury therefore believe that such periodic
adjustments as will be made under the new standard will be
consistent with the arm's length standard as embodied in U.S.
double taxation treaties.
E. Resolution of Bilateral Issues
The Service and Treasury recognize that implementation of
the commensurate with income standard in all its particulars,
including periodic adjustments, treatment of lump-sum
payments^ ' ^ and access to information to perform the necessary
analysis, may lead to differences with the competent authorities
i'» Id. at 54.
1^0 The objection raised in the report regarding the type
of analysis advocated in this report is not that it violates the
arm's length standard, but that it may call for more information
than can be practically obtained and analyzed by the tax
authorities. See id. at 15. As noted in Appendix D, the degree
of detail and analysis that will be called for under the new
methodology will depend in each case on the magnitude of the
potential for income shifting. Further, in cases of transfers of
routine intangibles, available comparable licenses will generally
obviate the need for almost all of this information.
^^^ See the discussion infra Chapter 8.
- 62 -
of our treaty partners and perhaps more general issues of treaty
policy and interpretation. Recognizing this, the United States
competent authority and the Treasury Department should be
receptive to the concerns of foreign governments, and endeavor to
seek bilateral solutions insofar as those concerns can be
accommodated in a manner consistent with Congressional intent in
enacting the commensurate with income standard.
F. Conclusions
1. The arm's length standard requires that each entity
calculate its profits separately and that related party
transactions be priced as if unrelated parties had
entered into them. Reference to the profits (including
the trend of those profits over time) of related
parties to determine a royalty in a licensing
transaction is intended to reflect what unrelated
parties would do and, therefore, is consistent with the
arm's length standard.
2. The arm's length standard as accepted by the
international community does not preclude reference to
profits of related parties to allocate income, but in
fact encompasses such an approach as a supplement to
the traditional approach of looking to comparable
transactions. It is, therefore, reasonable to conclude
that such an approach is consistent with international
norms as applied to situations in which comparables do
not exist.
3. The approach taken by Congress in enacting the
commensurate with income standard and the approaches
suggested in Chapters 8 and 11, infra , for implementing
that standard, including the provision for periodic
adjustments, are consistent with internationally
recognized arm's length principles. Applied in a
manner consistent with arm's length principles, the
commensurate with income standard is not likely to
increase international disputes over the right of
primary taxing jurisdiction.
4. The United States competent authority and the Treasury
Department should endeavor whenever possible to seek
bilateral solutions to problems that may arise with our
treaty partners in the interpretation and
administration of the commensurate with income
standard.
- 63 -
Chapter 8
PERIODIC ADJUSTMENTS
A. Introduction
As discussed in Chapter 6, an intangible transfer price that
is commensurate with the income attributable to the intangible .
must reflect the "actual profit experience realized as a
consequence of the transfer . "^ ' ^ The "commensurate with income"
language requires that changes be made to the transfer payments
to reflect substantial changes in the income stream attributable
to the intangible as well as substantial changes in the economic
activities performed, assets employed, and economic costs and
risks borne by related entities.
The Congressional directive to the Service to make
adjustments to intangible returns that reflect the actual profit
experience is in part a legislative rejection of R.T. French v.
Comm ' r . ^ ^ ^ That case endorsed the view that a long-term, fixed
rate royalty agreement could not be adjusted under section 482
based on subsequent events that were not known to the parties at
the original contract date. Thus, underlying the directive is
perhaps a view that contractual arrangements between unrelated
parties — particularly those involving high profit intangibles -
- are not entered into on a long term basis without some
mechanism for adjusting the arrangement if the profitability of
the intangible is significantly higher or lower than
anticipated. A very preliminary review of unrelated party
licensing agreements obtained from the files of the Securities
and Exchange Commission, discussed in Appendix D, and other input
received to date, seems to support this view. Indeed, as a
matter of long term business strategy, unrelated parties may
renegotiate contractual arrangements even absent explicit
renegotiation provisions to reflect revised expectations
regarding an intangible's profitability.^^*
^'2 1985 House Rep., supra n. 47, at 425.
i'3 50 T.C. 836 (1973).
^^* Since related parties always have the ability to
renegotiate contractual arrangements, explicit contractual
provisions permitting renegotiation of related party arrangements
would have little meaning and, therefore, should not be a
prerequisite for making adjustments. Furthermore, related party
contracts that contain these provisions will not necessarily lead
to results that conform to the experience of unrelated parties
operating under similar circumstances. If the contract proves
more profitable than expected, the parties can refuse to
renegotiate or adjust it, despite explicit provisions in the
- 64 -
Aside from the empirical evidence of what unrelated parties
seem to do, actual profit experience is generally the best
indication available, absent comparables, of anticipated profit
experience that arm's length parties would have taken into
account at the outset of the arrangement , It is, therefore,
perfectly consistent with the arm's length standard to treat
related party license agreements generally as renegotiable
arrangements and to require periodic adjustments to the transfer
price to reflect substantial changes in the income stream
attributable to the intangible.^'*
Intangible transfer prices will in any event be determined
on the basis of comparables if they exist. If a particular
taxpayer demonstrates that it has comparable long-term, non-
renegotiable contractual arrangements with third parties, the
arm's length standard will preclude periodic adjustments of the
related person intangible transfer price. In that event, a
comparable would exist by definition, which would determine the
consideration for the related person transfer, both initially and
over time. Comparables are always the best measure of arm's
length prices. In the case of a high profit intangible, however,
a third party transaction generally must be an exact comparable
in order for the transaction to constitute a valid comparable.^'*
It may also be possible in certain other cases to exclude
subsequent profit experience from consideration under the arm's
length standard. To do so, the taxpayer would need to
demonstrate each of the following to avoid an adjustment based on
subsequent profit experience:
contract which permit or require them to do so. Thus, requiring
that related party contracts mimic the terms of unrelated party
contracts will not alone ensure that the results experienced by
the related parties under those contracts will approximate arm's
length dealing. 1985 House Rep., supra n. 47 at 425-426.
Without the ability to make changes for adjustments over time,
related party agreements will be observed when they suit the tax
needs of the parties and amended or changed when they work to
their detriment. Compare R.T. French Co. v. Comm'r , 60 T.C. 836
(1973), with Nestle Co., Inc. v. Comm'r , T.C. Memo. 1963-14.
^'5 Periodic adjustments will also obviate the need for the
often fruitless inquiry into the state of mind of the taxpayer
and its affiliate at the outset.
17* See the discussion infra Chapter 11, regarding the
role of comparables in determining whether an adjustment over
time is necessary.
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1. That events had occurred subsequent to the license
agreement that caused the unanticipated profitability;
2. That the license contained no provision pursuant to
which unrelated parties would have adjusted the license; and
3. That unrelated parties would not have included a
provision to permit adjustment for the change that caused the
unanticipated profitability.
For example, assume that there are twelve heart drugs that
perform similar therapeutic functions, none of which has a
dominant market share- Several of these drugs are licensed to
unrelated parties under long term arrangements which do not
provide a mechanism for adjusting the royalty payments because of
subsequent changes. The taxpayer's drug, which is licensed to a
related party, uses an active ingredient which is different from
the other products with which it competes. The competitors'
drugs, however, lose all of their market share during the course
of the license agreement because their products are found to
cause serious side effects, and the licensed product's profits
increase dramatically. In this case, if the taxpayer could prove
the three factors above, the taxpayer could avoid an adjustment
based on the increase in profitability.
As noted earlier. Congress was particularly concerned about
taxpayers attempting to justify low-royalty transfers at an early
stage based on the purported inability to predict subsequent
product success.-^" Because of this concern, it would be
appropriate to impose a high standard of proof, such as a clear
and convincing evidence standard, on taxpayers in order to
demonstrate that subsequent profitability could not have been
anticipated. In no event should this test be available to
taxpayers if inexact comparable licenses with no provision for
periodic adjustments cannot be found in the marketplace -
A substantial change in intangible income will not
necessarily result in an adjustment. As discussed in Chapter 6
and described in Chapter 11, determining the intangible income is
merely the first step in the analysis of allocating intangible
income. The second step involves allocating income on the basis
of the activities performed and economic costs and risks borne by
the parties. If intangible income increases solely due to the
efforts of the transferee, then the increase in intangible income
will be allocated exclusively to the transferee, and no
adjustment will be made to the income of the transferor.
^'^ 1985 House Rep., supra n. 47, at 424.
- 66 -
B. Periodic Review
Annual adjustments may not be required to reach the
appropriate amount of Income under the commensurate with Income
standard. Adjustments are not required for minor variations In
Intangible Income, only for substantial changes In Intangible
Income.^'® Several Issues are raised by this requirement. How
often should the taxpayer review Its transfer pricing structure
to determine whether Income Is being properly reported and to
avoid potential penalties? How often may the Service make
adjustments in the course of examination? Should the regulations
define substantiality? Should the adjustments be applied
retroactively or prospectively? Should periodic adjustments be
made in the case of a sale of intangibles and other situations
Involving lump sum payments? Should set-offs be permitted?
The frequency with which a taxpayer should review its
related party Intangible transfer agreements and how often the
Service should be able to make adjustments are not questions
that can be governed by inflexible rules. When the transferee
experiences a substantial change in its profits from the
intangible resulting from some particular event (whether
anticipated or not ) , a review by the taxpayer is clearly
warranted; further, an adjustment by the Service is warranted
unless the taxpayer can demonstrate, by clear and convincing
evidence, that the conditions discussed above for avoiding an
adjustment based on subsequent profit experience are met. Even
absent a clear-cut event, it is possible that gradual changes
over time may create a substantial deviation from the parties'
expectations at the time they entered into the contract.
In general, taxpayers should review transfer pricing
arrangements relating to Intangibles (especially high profit
intangibles ) as often as necessary to assure that their transfer
prices are consistent with substantial changes in intangible
Income that may have occurred since the Inception of the current
transfer pricing arrangements. For industries that undergo rapid
technological change or for products that have a relatively short
life, this standard may dictate annual review. In short, the
taxpayer should review its pricing structure relating to
Intangibles as often and thoroughly as necessary to assure that
income is reported on its U.S. tax return in a manner that is
consistent with the commensurate with income standard. Taxpayers
that fail to do so risk the imposition of the substantial
understatement or other appropriate penalty.^"
^'* Id. at 426.
^'' As discussed supra in Chapter 3, the regulations or
statute should be amended to ensure adequate disclosure of
transfer pricing methodology and penalize unjustified
- 67 -
On the other hand, the Service should be permitted to make a
transfer pricing adjustment without necessarily having to
demonstrate that Its proposed adjustment Is justified by
Identifiable changes In Intangible Income compared with a prior
taxable year. In other words. If the adjustment can be supported
on the basis of exact or Inexact comparables, or on the basis of
the rate of return analysis or such other methodology as is
adopted by the Service for use in cases in which exact or Inexact
comparables do not exlst,^*° then the Service should not have to
demonstrate that the adjustment specifically relates to
identifiable changes in intangible income occurring since the
last taxable year examined. An approach whereby the Service
would be estopped from making an adjustment, absent clearly
identifiable changes in intangible income, because of the
Service ' s prior acceptance of some commensurate with Income
amount in a prior year would present problems of proof that are
not necessarily relevant to the appropriateness of the
adjustment. At most, consideration should be given only to
requiring that the proposed adjustment to income be substantial
In relation to the income reported by the taxpayer from the
transaction -- and then only for audits subsequent to the first
in-depth audit of transfer prices conducted for taxable years
after 1986.
It may be advisable to publish in the Internal Revenue
Manual a list of factors that, if one or more changes
substantially, would Indicate that there may be a substantial
change in intangible Income that may warrant an examination of
the taxpayer's Intangible transfer pricing. These factors might
include: (a) the size and number of markets penetrated; (b) the
product's market share; (c) the product's sales volume; (d) the
product's sales revenue; (e) the number of uses for the
technology; (f) improvements to the technology; (g) marketing
expense; (h) production costs; (1) the services provided by each
party in connection with the use of the intangible; and (j) the
product's profit margin or the process' cost savings.^ ®^
Any periodic adjustments that are made under the
commensurate with income standard generally should be made
prospectively -- i.e. , for the taxable year under audit and
subsequent taxable years (provided that there is no further
substantial change in the intangible income and other relevant
substantial understatements of tax resulting from nonconformity
to the arm's length standard.
180 See infra Chapter 11.
181 See also the factors set forth in Treas. Reg. §1.482-
2(d)(2)(lll).
- 68 -
facts). Unless unrelated parties would have set a different
royalty rate on the date of the transfer based upon expectations
of future high profitability or other facts known on the date of
transfer, the arm's length standard would require only that the
transfer price be commensurate with actual income -- i.e. , that
the transfer price be changed only as the intangible income
changes .
C. Lump Sum Payments
As discussed in Chapter 6, the commensurate with income
standard applies to transfers of intangibles by sale or license
for noncontingent, lump sum amounts. Thus, periodic adjustments
may be required under the commensurate with income standard in
the case of lump sum sale or royalty arrangements as well as
periodic royalty arrangements. In the case of a lump sura sale,
how should the Service make a section 482 allocation if it is not
apparent until many years after the sale that the lump sum
payment was insufficient under the commensurate with income
standard?
One possibility would be to recharacterize the sale as a
license, thereby giving the Service the ability to require
additional royalty payments sufficient to satisfy the
commensurate with income standard. It is clear, however, that
parties dealing at arm's length occasionally sell intangibles.
Thus, failure to recognize sale arrangements for related party
transactions could be viewed as a deviation from the arm's length
standard.
Alternatively, the Service could recognize the transfer as a
sale but make a section 482 allocation to increase the initial
lump sum payment. Unless taxpayers using lump sum sale
arrangements were required by regulation or statute to keep the
statute of limitations open for the payment year, the statute of
limitations could bar adjustments to a lump sum payment in closed
taxable years, contrary to Congressional intent. Moreover, other
problems would exist in adjusting the lump sum even if the
statute of limitations were open. For example, any mid-stream
adjustment to the initial lump sum made before the statute of
limitations expires on the year of sale would necessarily be
based on a projection of future profits over the remaining life
of the intangible that could be too high or too low.
Furthermore, any mechanism, whether elective or mandatory, that
would keep the statute of limitations for the year of transfer
open for extended periods would disrupt the examination process
by unduly delaying the closing of audits.
A lump sum sale arrangement should instead be treated as an
open transaction to assure that the sale over time satisfies
commensurate with income standard. This approach is the only
approach which recognizes the transaction as a sale, allows for
- 69 -
adjustments of the sale price under the conunensurate with income
standard, and minimizes the statute of limitation and other
problems inherent in making adjustments to income in the year of
the sale. Under this approach, a lump sum sale payment made in
the year of the transfer would result in gain taxable in the year
of transfer but would then be treated as a prepayment of the
commensurate with income amounts. No section 482 allocation
would be required until the aggregate commensurate with income
amounts exceed the prepayments.
Under this method, the lump sum is treated as invested on
the date of the lump sum payment in a hypothetical certificate of
deposit ("CD.") maturing on the last day of taxpayer's current
tax year bearing interest at the appropriate federal funds rate
based on the anticipated life of the intangible (for U.S.
developed intangibles) or the appropriate rate in the development
country. At the end of year one the balance of the CD.
investment would be computed. From this amount, the amount of
the commensurate with income amount would be subtracted. The
remaining balance would then be treated as invested in a CD.
maturing at the end of year two. At the end of each tax year a
computation similar to that done at the end of year one would be
made. When the CD. balance is exhausted, the taxpayer would be
required thereafter to include the entire commensurate with
income amount in income each year.
Consider, for example, an intangible that is transferred for
$1,000 and that would demand a commensurate with income amount
in each of ten years as shown:
Col,
Col. 2
Col. 3
Year
Lump sum $1000
payment increased
by time value
Remaining lump
return ( assume
sum ]
payment at
10%) at end
beginning of
of year
Commensurate
year
(prior
(Col. 3 plus
with Income
year
Col. 1
returns on
Amount
less
prior year
Col . 3 amount )
( assumed)
Col.
2)
1
$ 1100
$ 100
$
1000
2
1100
100
1000
3
1100
200
900
4
990
200
790
5
850
200
650
6
715
500
215
7
237
500
-0-
8
500
-0-
9
200
-0-
10
200
-0-
- 70 -
The $1,000 lump sum payment would be converted as shown in column
1 into a stream of income which is offset by the commensurate
with income amount in column 2 until the stream of income is
exhausted in year 7. Thereafter, the commensurate with income
amount would be fully included in the transferor's income.^ *^
Because section 482 may be applied only by the Service, no
refunds could be allowed if an excessive lump sum was paid.
However, to prevent abuse of outbound lump sum payments in
inbound licensing arrangements, the Service would be allowed to
adjust excessive lump sum payments that clearly exceed the
commensurate with income standard.
D. Set-Offs in Royalty Arrangements
It is possible that the initial royalty rate set by the
parties could be too large in some years and too small in other
years when analyzed under the commensurate with income standard.
Under existing regulations, section 482 adjustments traditionally
have been made on a year-by-year basis. Only intra-year set-offs
of proposed adjustments against excessive income derived on
related party transactions are authorized under section 1.482-
^*2 It has been suggested that the commensurate with income
standard will result in all gains from the sale of intangibles
being treated as royalties under the Internal Revenue Code and
under our tax treaties, because of the provision in the Code and
those treaties covering gains contingent on productivity, use or
disposition of the relevant intangible. There is no intention by
the Service or Treasury to eliminate the possibility of sale
treatment for transfers of intangibles in appropriate cases,
either for treaty purposes or for U.S. withholding tax purposes.
Further, the Service and Treasury believe that the mere fact that
subsequent profits may be taken into account in appropriate cases
by U.S. tax authorities in determining transfer prices on audits,
or that a lump sum is treated as a deposit on the appropriate
section 482 transfer price in order to assure that a commensurate
with income adjustment can be made notwithstanding the statue of
limitations, does not have this effect. The terms of the
transaction itself ( i.e. , whether it provides for contingent
consideration based, e.g. , on sales volume or units sold) will
determine treatment under the royalty article. Further, even if
the commensurate with income standard were incorporated by
reference into the relevant sales document, there is no necessary
relationship between productivity, use or disposition and a
proper commensurate with income payment. For example, sales
might increase dramatically in a given year, but the method
called for may result in no increase in payments, or the taxpayer
may have an arm's length basis for making no adjustment.
- 71 -
1(d)(3) of the regulations.^'' Thus, the Service could make
adjustments in some years without making an allowance for
excessive royalties paid in other years. Assume, for example,
that a license generates a fixed royalty amount on an intangible
that produces fluctuating income due to business cycles or
changes in demand. Over time, the royalty may be an appropriate
one on average, but in some years it may be too low and in others
too high.
Because of the problems inherent in an open transaction
approach, the current rule prohibiting multi-year set-offs should
be retained. The potentially harsh effect of this rule will be
mitigated by the fact that periodic adjustments generally should
be made only in cases of substantial changes in circumstances and
by the ability of taxpayers to adjust their own arrangements
prospectively, reducing or increasing the royalty, to account for
changed circumstances. It will also create an incentive for
taxpayers to examine their arrangements periodically to see
whether an adjustment favorable to them would be appropriate.
E. Conclusions
1. Periodic adjustments are necessary in order to reflect
substantial changes in the income stream produced by a
transferred intangible, taking into account the
activities performed, assets employed, and economic
costs and risks borne by the related parties.
2. Requiring periodic adjustments is consistent with the
arm's length principle, since unrelated parties
generally provide some mechanism to adjust for change
in the profitability of transferred intangibles and
since actual profit experience generally is the best
indication available of the anticipated profit
experience that unrelated parties would have taken
into account at the outset of the arrangement.
3. Taxpayers should review transfer pricing arrangements
relating to transferred intangibles as often and as
thoroughly as necessary to assure that income is
reported over time in a manner consistent with the
commensurate with income standard.
4. Periodic adjustments made under the commensurate with
income standard generally should be prospective unless
a different royalty rate would have been set on the
date of transfer based upon expectations of the parties
and the facts known as of the date of transfer.
i"' But see Treas. Reg. §1 • 482-2( d ) ( 1 ) ( ii ) ( d) , Ex. 3, which
appears to allow an inter-year set-off.
- 72 -
A lump sum sale of an intangible should be
characterized as an open transaction whereby the lump
sum sale payment results in gain at the time of
transfer, but is then treated as a prepayment of the
commensurate with income amounts- No section 482
allocation would be required until the aggregate
commensurate with income amounts exceed the prepayment.
Multi-year set-offs of proposed adjustments against
excessive related party income derived in other taxable
years will not be permitted.
- 73 -
Chapter 9
THE NEED FOR CERTAINTY: ARE SAFE HARBORS THE SOLUTION?
A. Introduction
One of the most consistent criticisms of the section 482
regulations is that they do not provide taxpayers with enough
certainty to establish intercompany prices that will satisfy the
Service without overpaying taxes. Based on the government's
experience in litigation, the current section 482 regulations
also fail to provide the Service and the courts with
sufficiently precise rules to make appropriate section 482
adjustments, especially when third party comparables are not
available.^®* One of the most common suggestions for solving
these problems is to amend the section 482 regulations to adopt
safe harbors, or simple, mechanical, bright-line tests that may
be used in lieu of the fact-specific arm's length inquiry under
section 482.^^5
B. General Problems with Safe Harbors
While numerous safe harbors have been proposed, they
generally have taken two forms: (1) absolute safe harbors that
grant the taxpayer total freedom from a section 482 adjustment
once the criteria for the safe harbor are satisfied, and (2)
conditional safe harbors that produce a rebuttable presumption or
a shift in the burden of proof in the taxpayer's favor, but that
may be overcome by the Service through evidence showing that a
section 482 adjustment is necessary.
Although various types of safe harbors are available, they
all have one common element that makes them both attractive to
the taxpayer and potentially troublesome to the government: they
generally would serve only to reduce tax liability. Taxpayers
for which a safe harbor would produce a lower tax liability than
the appropriate normative rule would use it. Those for which a
safe harbor would produce a higher tax liability than the
appropriate normative rule generally would not seek the
protection of the safe harbor but would apply the normative rule.
Reducing administrative costs, or the need for certainty, may
encourage some taxpayers to use a safe harbor in marginal
situations even if application of the normal rule would result in
^^* GAO, IRS Could Better Protect U.S. Tax Interests , supra
n. 64, at 63; ABA Comm. on Affiliated and Related Corporations,
Administrative Recommendation No. 8 (1986) [hereinafter ABA
Admin. Rec. ] ; Langbein, supra n. 160, at 655.
^"^ See GAO, IRS Could Better Protect U.S. Tax Interests ,
supra n. 64, at 48-50.
- 74 -
a tax savings. In general, however, the only benefit a safe
harbor offers from the Service ' s perspective is a saving of
administrative costs.
Ideally, safe harbor standards should be easy and
inexpensive vehicles for selecting cases that warrant closer
scrutiny. The perfect safe harbor would result in the
elimination of all insignificant cases and the selection of
cases for detailed analysis by taxpayers and further examination
by the Service that would more likely produce sustainable,
significant adjustments if analyzed incorrectly by the taxpayer.
The question is whether there are any safe harbors that are
capable of approaching these goals.
A look at the Seirvice's experience with section 482 safe
harbors is instructive. The best example is the safe harbor for
interest rates found in section 1 .482-2( a) ( 2 )( iii ) . From the
Service's point of view, results under this safe harbor have
been mixed at best. The safe harbor was originally set between 4
and 6 percent. This was probably sufficient in 1968, but it
soon became inappropriately low. However, the government was
very slow to change the safe harbor range as interest rates
rose.^** The safe harbor for interest now tracks the Federal
rates required to be determined for purposes of the original
issue discount rule under section 1274(d), which reflect market
rates and are adjusted monthly. While this is probably a
satisfactory solution, many taxpayers were able to gain a
substantial windfall while the government made successive
attempts to choose an appropriate safe harbor rate.
Another example of a safe harbor is found in section 1.482-
2(c)(2) (ii) of the regulations, which provides a safe harbor
computation of an arm's length rental for the use of tangible
property. Experience has demonstrated that this safe harbor was
overly generous to taxpayers ( i.e. , requiring too little rent).
It was repealed by regulations finalized this year.^*' No
substitute safe harbor has been provided to date.^"'
The government ' s experience in the section 482 area has been
that safe harbors have generally treated amounts as arm's length
186 ijijjQ following changes have been made to the safe
harbor interest rate: 6-8 percent effective January 1, 1976; 11-
13 percent effective July 1, 1981; 100-130 percent of the
applicable Federal rate effective May 9, 1986. Final regulations
were published on June 13, 1988. T.D. 8204, 1988-24 I.R.B. 11.
1"^ T.D. 8204, 1988-24 I.R.B. 11.
188 See Treas. Reg. S1.482-2(c)(2 )(ii ) .
- 75 -
that were usually different from market rates. This result is
even more likely to occur in the transfer pricing area because of
the inherent difficulty of constructing valuation safe harbors
for the types of intangible and tangible property that have
created transfer pricing problems under section 482.
Furthermore, because of the complexity of the regulatory process
and the difficulty in obtaining reliable data, adjustments or
corrections to safe harbor standards would be slow. In any
event, the fundamental deficiencies of safe harbors are not
resolved by continually reviewing and revising the rates, or by
intentionally setting the safe harbor on the conservative side
for protection of the revenue. If safe harbors are set at non-
market rates, they will be used only by taxpayers that will
benefit by making or receiving payments at those rates..
C. Specific Proposals
The following lists some of the safe harbors that have been
proposed and includes a short explanation of some of the reasons
why they have not been endorsed by the Service and Treasury.
1. Pricing Based on Industry Norms . This approach is
contrary to the legislative history of the section 482 changes in
the 1986 Act.^*' Industry norms generally do not reflect arm's
length prices for highly profitable intangibles. Accordingly,
any safe harbors based on industry norms or statistics would
permit transfer prices that would be far different from the arm's
length standard in the most significant cases.
2. Profit Split — Minimum U.S. Profit . This approach
would guarantee that the United States would capture a certain
minimum of the profit in transfer pricing cases, perhaps 50
percent. The commensurate with income standard is designed to
divide the income involved between related parties to "reasonably
reflect the relative economic activity undertaken by each.''^'° A
safe harbor that splits profits a certain way in all cases would
be inconsistent with the case-by-case factual determination that
is necessary to measure the economic contribution made by each of
the related parties. Furthermore, a fixed U.S. profit
requirement would be objectionable to other countries when
intangibles were developed outside the United States.
18' 1985 House Rep., supra n. 47, at 424-25.
1'° Id.
- 76 -
3. Profit Split Based on Taxpayer's Proportionate Share of
Combined Costs (ABA Proposal ) .^ ^ ^
The problem with this safe harbor is that it presumes that
different types of expenses contribute equally to the combined
profit. For example, expenses Incurred for highly skilled
technical services might contribute proportionately more to the
combined profit than those incurred for unskilled services.
Furthermore, it might be very difficult to determine what
Indirect expenses (including, for example, research and
development expenses) are attributable to particular products,
and taxpayers might be able to manipulate the profit split by
shifting expenses from one product to another or one entity to
another (such as by "loaning" employees).
4. Profit Split Based on Share of Combined Costs and
Assets (ABA Proposal ) .^ ^ ^ The second ABA safe harbor Is a
modification of the first one. Instead of relying entirely on
relative expenses, it relies 50 percent on expenses, and 50
percent on the fair market value of the assets used In the
production of the property involved in the sale. However, at a
minimum not less than 25 percent of the combined taxable Income
would be allocated to the buyer. If one of the parties employed
its assets in a very inefficient manner, it would nevertheless be
rewarded in the same manner as if it were highly efficient.
Additionally, assets could be arbitrarily shifted from one entity
to another; difficult questions of property valuation could
arise; and property could be purchased just to tip the balance of
profits. Because of those problems, a party could receive a
substantial amount of the combined taxable Income, yet be doing
very little to earn the Income.
5. Insubstantial Tax Benefit Test . This safe harbor would
be available if the rate of tax in the foreign jurisdiction was
at least 90 percent of the U.S. rate. The theory behind this
safe harbor is that taxpayers will use arm's length pricing if
no overall tax savings result from doing otherwise. While this
approach may have some pragmatic appeal, there are still several
problems with it. An adjustment under section 482 does not
depend on an intent to avoid taxes. Even if the taxpayer is
overpaying its worldwide tax liability, if U.S. income is being
^'^ ABA, Admin. Rec , supra n. 184, a,t 14. The ABA
proposals are applicable only to the transfer of tangible
property. Other proposals apply only to Intangible property.
Because many of the safe harbors would have the same advantages
and disadvantages regardless of the type of property Involved,
this discussion does not address the different types of property
separately.
19 2
Id. at 14-15.
- 77 -
understated, an adjustment should be made. Furthermore, as a
policy matter the United States will not cede its taxing
jurisdiction to a foreign country other than by treaty.
Accordingly, if a taxpayer intentionally or inadvertently shifts
income to a high tax jurisdiction it should be subject to a
section 482 adjustment without the benefit of a safe harbor. As
a practical matter, however, the Service proposes relatively few
adjustments between a U.S. -based parent company and its
affiliates located in another jurisdiction whose effective tax
rate is nearly the same or higher. Different problems are
presented by foreign-based parents and their U.S. affiliates.
6. Profit Distribution Test . This safe harbor would be
satisfied if at least 25 percent of the pre-royalty net profit
of an affiliate was distributed to the parent. This test is
directly contrary to the commensurate with income concept. If an
affiliate is responsible for only 10 percent of the economic
activity in question it should not be able to keep up to 75
percent of the profit involved.
7. Prior Settlement Test . Under this proposal, when the
Service had accepted a specific pricing method in a prior
examination, the burden would be on the Service to show that the
pricing method is unreasonable for the current year. This safe
harbor is unacceptable because there could be any number of
reasons why the Service had accepted a particular pricing method.
To force the Service to demonstrate that the previously agreed
upon method has become unreasonable could help perpetuate an
error or make it more difficult to adjust to changing
circumstances.
D. Burden-Shifting Safe Harbors
Some of the safe harbor proposals would operate by shifting
the burden of proof to the Service. It has been proposed, for
example, that a taxpayer's full disclosure of the method by which
it determines its transfer prices would shift the burden of proof
to the government. (See Chapter 3, supra , for a description of
lEs' experiences in seeking information.) Section 6001 requires
all taxpayers to maintain adequate books and records to
substantiate positions taken on the tax return, including section
482 issues. Thus, a taxpayer could obtain a shift in the burden
of proof merely by complying with the law.
The Service and Treasury do not believe that "burden-
shifting" safe harbors are a viable approach. The critical
issues presented in the section 482 area are almost always
factual in nature, and taxpayers are almost always uniquely
familiar with -- and in exclusive possession of -- the relevant
facts. To place the burden of proof on the government in this
situation would be unworkable.
- 78 -
E. Conclusions and Recominendatlons
1 . Historical experience with safe harbors indicates that
they generally result in unwarranted windfalls for
taxpayers, without significant benefits for the
government.
2. In the highly factual section 482 context, no one safe
harbor or combination of safe harbors has yet been
proposed that would be useful but not potentially
abusive .
3. While the possibility that useful safe harbors could
be developed is not categorically rejected, additional
section 482 safe harbors are not recommended at the
present time.
- 79 -
III. METHODS FOR VALUING TRANSFERS OF INTANGIBLES
A significant reason for the enactment of the commensurate
with income standard was the failure to properly take into
account the income earned by related parties in exploiting
intangibles. As detailed in earlier chapters, inappropriate
comparables or ad hoc profit split approaches have been used to
analyze cases involving related party transfers of unique
intangibles.
This part of the study seeks to define the appropriate use
of comparable transactions. It also proposes an alternative
method of analysis that does not directly rely upon comparable
transactions. Fourteen detailed examples applying the methods
described in this part are set forth in Appendix E. These
methods are generally consistent with various methods of income
allocation used by the Service, taxpayers, and the courts under
pre-1986 Act law and, if adopted, would appropriately be
applicable to cases arising prior to the 1986 Act.
Chapter 10
ECONOMIC THEORIES CONCERNING THE IMPLEMENTATION OF SECTION 482
A. Introduction
The current section 482 regulations use a market-based
approach to income allocation. The goal of this approach is to
distribute income in the same way that the market would
distribute the income; that is, related parties should earn the
same returns that unrelated parties would earn under similar
circumstances. This approach is implemented through separate
accounting in which an individual transfer price is determined
for each transaction.^'^
The argument for the market-based method to allocate income
was articulated by Stanley Surrey, former Assistant Secretary
(Tax Policy), who discussed the way that unrelated parties are
taxed:
Tax administrators do not question transactions that
are governed by the marketplace. If Company A sells
goods to unrelated Company B at a certain price or
furnishes services at a particular price, the income of
both companies is determined by using that price. One
^'^ A variation of this approach retains the goal of a
market-based allocation but claims that in some situations the
target is best reached by an estimate, or that average prices can
be used for certain transactions. The estimate can be provided
by some type of formulary apportionment.
- 80 -
company may be large and the other small; one may be a
monopoly; one may be financially strong and the other
in a weak condition. But these and other factors which
may affect the price at which the transaction occurs
are not the concern of the tax administrator.^'*
Having established the tax system's acceptance of the
marketplace, he concludes:
Presumably, most transactions are governed by the
general framework of the marketplace and hence it is
appropriate to seek to put intra-group transactions
under that general framework. Thus, use of the
standard of arm's length, both to test the actual
allocation of income and expense resulting under
controlled intra-group arrangements and to adjust that
allocation if it does not meet such standard, appears
in theory to be a proper course . ^ ' *
Recent criticism has questioned whether the market-based
arm's length approach is flawed as a matter of general principle.
An alternative approach might be based on the concept of an
integrated business. Loosely defined, an integrated business
consists of firms under common control and engaged in similar
activities. Proponents of the alternative approach assert that
one cannot assume that related parties conduct market-based
transactions within the entity. They claim that, because an
entity will not act as if its parts are unrelated, it does not
make sense to try to account for individual transactions in the
way that unrelated parties subject to market forces would account
for similar transactions. Under this theory, the allocation of
income can only be accomplished by applying some formula chosen
by the government.
This chapter explores the tension between these alternative
approaches, and suggests a way to apply the arm's length
principle to an integrated business. It concludes that the
market-based arm's length approach remains the best theoretical
allocation method.
B. The Arm's Length Approach in an Integrated Business: Theory
The goal of a market-based approach is to ensure that the
return to an economic activity is allocated to the party
performing the economic activity. Critics of the market-based
19* Surrey, Reflections on the Allocation of Income and
Expenses Among National Tax Jurisdictions , 10 Law and Policy in
International Business 409, 414 (1978).
^'5 Id. at 414.
- 81 -
approach argue that an arm's length price will not achieve this
goal. Relevant practical issues are how close one can get to the
right price and whether getting that price is costly relative to
settling for an estimate.
One commentator has suggested that the difficulties
encountered in administering the current regulations stem not
from practical considerations, but rather from fundamental
problems inherent in applying a market-based approach to
transactions of integrated businesses.^" Specifically, it has
been argued that the flaw in an arm's length approach is that it
does not allow a return to the form of organization. That is,
because an integrated enterprise is presumably more efficient,
it will be able to execute an integrated economic activity at a
lower cost than a series of independent firms whose joint efforts
are necessary to execute the same series of transactions. This
omission creates a "continuum price problem, " a situation in
which the sum of the returns for separate services rendered by
independent parties is less than the actual return of the
combined group. This argument grows out of the literature on the
reasons for the existence of multinationals.^'^
That multinationals may exist because of integrated or
"firm-specific" economies does not require a rejection of the
arm's length principle. Transfer prices are supposed to reflect
the contribution of the activity and assets utilized in each
location to economic income. Therefore, each party should earn
at least as much as it could have earned as an unrelated party
under alternative arrangements.
Furthermore, an analysis of "alternative arrangements" need
not be restricted to analyzing conventional arm's length
transactions. Consider a U.S. firm that owns the worldwide
rights to a unique patented drug that it wishes to sell into a
new market (and assume that the drug or patent is valuable in its
own right and that marketing activity, for example, is not an
important factor). The firm could license the use of the patent
to unrelated parties to produce the drug in the new market.
Alternatively, the firm could enter into a joint venture by
^'* Langbein, supra n. 160, at 627.
1" Caves explains that many multinationals exist because
of a failure in the market for intangibles. R. Caves,
Multinational Enterprise and Economic Analysis (1982). In
essence, intra-firm transactions can be more profitable than
inter-firm transactions because of the expense of negotiating
complete contracts or the inability of a firm to capture the full
value of a piece of knowledge through contracts with unrelated
parties without fully explaining the knowledge and thus
eliminating its value.
- 82 -
affiliating with a company that has the ability to produce the
drug. If the pharmaceutical firm entered into a joint venture it
would probably be able to negotiate a very large share of the
profits given the value of the patent, because any number of
local firms could provide the labor and capital necessary to mix
and package the drug.
There are, therefore, two types of arm's length transactions
to consider -- one in which the parties remain independent and
another in which the two parties make an arm's length agreement
to affiliate by merger, joint venture, acquisition, or simply
through the hiring of local labor and capital within a
subsidiary. Restricting attention to transactions between
parties that remain unrelated can fail to accomplish the
objective of allocating to each party its contribution to income,
if such transactions do not accurately reflect the actual
relations between the related parties.
Another way of describing the arm's length agreements that
have to be considered is to say that they are the arrangements
that would be made between unrelated parties if they could choose
to have the costs of related parties -- i.e. , to use the related
party technology. In general, tax rules should distort business
decisions as little as possible because rules that minimize such
distortions will lead to the greatest possible production
efficiency. Transfer pricing rules will allow the most efficient
production technology to come to the fore if, holding the cost
functions constant, they result in the same tax burdens whether
or not the parties are related. In other words, if unrelated
parties somehow had access to the technology available to related
parties, their operations should not result in more or less total
taxes than would be paid by a multinational using this
technology. The difficulty, of course, is the practical
application of this interpretation of the arm's length standard.
C. The Arm's Length Approach in an Integrated Business:
Practice
The arm's length approach can be more correctly applied to
an integrated business by using certain tools of microeconomic
theory. The continuum price problem arises when a vertically or
horizontally integrated production technology that is available
to multinational corporations results in lower costs than a non-
vertically or horizontally integrated technology, which unrelated
parties would have to use. How can an examination of unrelated
party transactions lead to a satisfactory resolution of the
transfer pricing problem?
As a first step, consider an industry in which there is no
difference in costs between related party and unrelated party
dealings; there is only one production technology, and it is
available to the parties in both types of arrangements. There
- 83 -
is thus no continuum price problem, and the arm's length
standard, as traditionally interpreted, can be applied. It is
likely that both unrelated party and related party transactions
will actually occur in the marketplace, and it should be possible
to observe prices from the former and use them to determine the
incomes of each party in the latter.
This procedure satisfies the objective described in section
B above of using information about unrelated parties operating at
arm's length to determine the allocation of income in the related
party setting. The related parties that sell intermediate goods
will be given the same gross revenues as the corresponding
unrelated parties; related parties that purchase them will have
the same cost of goods sold as corresponding unrelated parties.
Further, it has already been assumed that the two sets of parties
operate in the same market and have the same cost structure;
therefore, the external prices and internal costs will be equal.
Thus, the related parties will have the same net taxable incomes
as the corresponding unrelated parties. They should therefore
have the same total tax burden as the unrelated parties with
which they are competing.
Now return to the situation in which a vertically or
horizontally-integrated technology, available only to
multinational companies, is dominant. If multinational
corporations are able to produce at lower cost, then in the long
run it should be difficult for the smaller companies to continue
in existence. Therefore, arm's length prices may be unavailable.
An appropriate transfer pricing result will be achieved if each
related party were assigned the income that the corresponding
unrelated party would earn, if the latter were using the
efficient cost structure.
Microeconomic theory leads to an unambiguous and natural
statement of what the income of unrelated parties should be in
these circumstances. As long as the industry under analysis is
competitive and the factors of production are homogeneous and
mobile between sectors, it is assumed that "economic," "excess,"
or "above-normal" profits will be zero in the long run.^'^ That
is, each firm will earn just enough to be able to pay for the
land, labor, capital, and other factors of production that it
uses to produce its outputs.
The zero economic profit concept does not state that taxable
income should be zero. If owners of the firm have supplied it
^" For a narrative explanation of the zero profit
condition, see R. Lipsey and P. Steiner, Economics 229-231 (6th
ed. 1981). For a mathematical presentation of the implications
of this condition, see J. Henderson and R. Quandt, Microeconomic
Theory 107-110 (3d ed. 1980).
- 84 -
with capital or other inputs, the firm should earn enough to be
able to reward the shareholders for these factors; otherwise, the
shareholders would be wise to find a better investment. Rather,
the zero profit concept implies that in a competitive industry
there should be an equality between the gross revenues of a firm
and the summation of the market returns that are or could be
earned by all of the factors of production that the firm employs.
If gross revenues were higher than this amount, then the firm
would be earning "above-normal" profits; the existence of
"above -normal" profits would attract other firms to enter the
industry until these "above -normal" profits disappeared through
competition. If gross revenues were lower than this amount, a
firm would not be able to earn enough to reward all of the
factors it employs and, in the long run, would have to shrink or
disappear.
This equality between revenue and the sum of returns to each
factor of production may be used to determine the proper
allocation of income among the related parties within the
multinational. Specifically, subject to the discussion in
section D infra regarding monopoly situations and intangibles,
one should measure the factors of production used by each
related party and compute the returns that each one would earn on
its best alternative use in the marketplace. The sum of these
amounts yields the total input returns that each related party
would have to earn if it were an unrelated enterprise. The sum
also equals the amount that the multinational enterprise would
have to pay an unrelated party to get it to produce the same
outputs (employing the same inputs and using the same technology)
as the related party does. Attributing this gross income to each
related party will result in its tax base being equal to the
hypothetical unrelated party alternative; therefore, the tax
burden will be equal. Thus, there will be no tax incentive or
disincentive to related party transactions.
The theory discussed above implies that a competitive firm's
gross revenue, which equals price times quantity of output, will
be equal to the returns that the factors it employs could earn in
the marketplace. The traditional arm's length approach looks at
the gross revenue side of this equation; the alternative
procedure outlined above looks at the input side. It starts by
identifying the factors of production employed by the firm,
determining the returns that these factors would earn in the
marketplace, and computing the sum. In short, the traditional
approach looks for the prices that the firm's outputs would
command in the marketplace, whereas the alternative approach
seeks to determine the returns that the firm's factors would earn
in the marketplace. Both approaches are equally consistent with
the basic goal of the arm's length principle, which is to use
information about unrelated parties operating at arm's length to
determine the allocation of income in a related party setting.
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D. Further Practical Problems
There are two further practical difficulties in applying the
arm's length approach to integrated business economies:
application of the approach to monopoly situations and valuation
of intangibles. This section briefly describes these
difficulties and suggests possible approaches to solving them.
1. Monopoly Situations . In a market that cannot be entered
by more than one or a few firms, the existence of "above-normal"
profits cannot be ruled out, because potential competitors will
not be able to compete them away. The equality discussed above
between gross revenue and the returns that factors could earn in
the marketplace, and the results derived from it, cannot then be
assumed to hold.
However, it may still be possible to apply the basic idea.
For example, consider a situation in which a corporation has been
granted worldwide patent rights to a unique product. The company
still can choose between exploiting this patent through related
party or unrelated party dealings, and it would be worthwhile for
this decision to be made free of distortions that could be caused
by transfer pricing rules. To get an unrelated corporation to
provide a good or service, the company would have to pay the
unrelated corporation the sum of the returns that would be earned
by the factors it would employ. Therefore, it would still be
proper to use the alternative procedure to determine the income
of the related corporation.^"
2. Valuation of Intangibles . The starting point for the
alternative application of the arm's length approach is to
measure the factors of production employed by the related
parties, and to determine the returns that they would earn in the
^" In more complicated situations, both the affiliated
corporation and any potential unrelated party participant may
each possess monopoly rights that allow them to earn above-normal
profits. In deciding whether to use such an unrelated party, a
corporation would have to consider what would happen if it
attempted to bargain with it. There are analyses, relating to
economic game theory, that attempt to predict what the range of
outcomes would be in such a bilateral monopoly situation. If the
outcome, specifically the income of the potential unrelated
party, can be predicted, then it would be proper to use it to
determine the income of the corporation's affiliate. This is so,
to repeat, because this procedure would allow the corporation's
choice between using an affiliate versus an unrelated party to be
made free of tax distortions. To implement this procedure,
however, one would need to analyze the theoretical models of
bargaining situations in detail, and this analysis is beyond the
scope of the present discussion.
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marketplace. This procedure can be implemented in a straight-
forward fashion only if the factors can be identified and
measured.
However, there is at least one factor of production,
intangible assets, for which it is often difficult to assign a
precise value. These assets are often unique and it is
frequently difficult to decide what returns they would earn if
separately employed in the marketplace.
One should not conclude that the presence of any intangible
asset will make the alternative procedure impossible to
implement. It may be that only one of the related parties
employs intangible assets to any significant degree. In this
situation it suffices to measure the factors of production
employed by the party with measurable assets and to allocate the
residual income to the related party employing significant
intangible assets. If both parties employ intangible assets,
valuation becomes more difficult and, in some cases, judgmental,
but not impossible.
E. Conclusions
1. The arm's length standard remains the theoretically
preferable approach to income allocation.
Microeconomic theory can be utilized to apply the arm's
length standard to an integrated operation.
2. In certain situations, production technologies may be
such that unrelated parties operating at arm's length
can be expected to coexist with vertically or
horizontally integrated multinational corporations. In
these cases, arm's length prices should exist and their
application to related party transactions should lead
to appropriate results. This is the traditional
approach embodied in the section 482 regulations.
3. In other situations, vertically or horizontally
integrated technologies available only in related party
dealings may dominate. Third party prices will be
difficult to find in these cases; moreover, the use of
the rare third party prices that occur may be
inappropriate. However, since information may exist as
to the arm's length returns attributable to the factors
of production employed by one or both of the related
parties, this information can be used to modify the
traditional approach and take account of the integrated
businesses.
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Chapter 11
ARM'S LENGTH METHODS FOR EVALUATING
TRANSACTIONS INVOLVING INTANGIBLE PROPERTY
A. Introduction
This chapter discusses the methodology for implementing the
arm's length principle for transactions involving intangible
property. The goal of this chapter is to propose a theoretical
framework for analyzing the situations that have caused the
greatest amount of difficulty in the transfer pricing area in
order to generate further consideration of the difficult issues
involved.
B. Role of Comparable Transactions
"Exact comparables, " which are those involving the transfer
of the same intangible property, supply the best evidence of what
unrelated parties would do in a related party transaction. The
weight to be given to evidence of "inexact" comparables, which
generally are those involving different but economically similar
intangible property, is not so clear. Nor is the resort to
inexact comparables automatically justified by the arm's length
principle. This section first outlines the standards for exact
comparables. It then discusses the appropriate role for inexact
ones.
1. Exact Comparables : Two Examples
Exact comparables are most likely to occur in connection
with the transfer of common products that embody intangibles that
are widely available to producers, such as the once unique
technology now employed in pocket calculators, digital watches,
or microwave ovens. Comparability in such cases of widely
available technology is usually easy to demonstrate.
The existence of an exact comparable for unique intangible
property, however, is not inconceivable. Consider a
multinational company that acquires an unrelated company whose
only assets are a small amount of cash, equipment, and the rights
to a valuable new invention. If, immediately after this
acquisition, the multinational sells those rights to a
subsidiary, there really can be no question as to the proper
transfer price: it is the acquisition price minus the cash and
value of the equipment. In fact, because this comparable is
available, any other arrangement could be held suspect. Assume
further that the subsidiary and the parent have no other
transactions in the initial and following years. The
subsidiary's income should include the return to the intangible
in all future years, assuming that the subsidiary paid the arm's
length consideration at the time of the initial transfer.
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As a second example, consider a U.S. corporation that
decides to exploit one of its intangibles. It sets up a Mexican
subsidiary to serve the Latin American market, while it licenses
the Asian rights to an unrelated Korean company. Assume further
that the Asian and Latin American markets, and the parent's
dealing between the Korean company and the Mexican subsidiaary,
are comparable in all important aspects. The Korean licensing
arrangement should determine the Latin American subsidiary's
allocation of income from the transfer of the intangible.
2. Standards For Exact Comparables
The assumptions made in these examples raise the crucial
question: How is one to know if a potential comparable is indeed
exact? The first requirement is that the comparable transaction
involve the same intangible property transferred under
substantially similar circumstances. Thus, an exact comparable
should involve the same patent, product design, process,
trademark, or other intangible transferred to the related party.
However, licenses of intangibles are usually exclusive.
Therefore, it is extremely unlikely that the same intangible
would be licensed to two different parties for the same use and
geographic market. The standards for exact comparables should
not require these aspects to be identical.
Instead, two types of additional standards should be met.
First, the comparable transaction and the related party
arrangement must take place in substantially similar economic
environments; these standards may be called "external" ones.
Second, the transactions must contain substantially similar
contractual features; they must satisfy "internal" standards of
comparability.
No amount of general discussion of these standards is
likely to turn them into objective tests. As in all matters
concerning transfer pricing, facts and circumstances must
determine the outcome of specific cases. The following
observations, however, may suggest some useful guidelines.
a. "External" Standards
In examining external standards, the essential question is
whether unrelated parties would regard the economic environment
of the transaction under examination as similar to that of the
proposed comparable transaction. In other words, would unrelated
parties earn substantially similar profits from a substantially
similar transaction? For example, the size and level of economic
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development of the markets should be substantially similar.2°°
If one market is much larger, or if the product is already
accepted in one market and not the other, one can presume that
unrelated parties would not arrive at the same arrangements to
license an intangible into these two markets. As another
example, one market may contain many competitors, but in the
other a licensee can expect to have a monopoly for a number of
years. Again, it is reasonable to conclude that unrelated
parties would come to different terms in negotiating licenses for
these markets.
Another set of external standards concerns transactions
between the licensor and licensee that are collateral to the
transfer of the intangible in question. If the parties to one
transaction have substantial dealings in the intangible with
third parties (such as a cross-licensing arrangement) but the
parties to the other set of transactions do not, external
standards of comparability are not satisfied. There are clearly
reasons why unrelated parties will reach different outcomes if
they expect to have further dealings than if they do not. For
example, an isolated exchange should not be taken as exactly
comparable to a continuing transactional relationship. The
comparable used in the U.S. Steel decision^ °^ has been
criticized on this basis.
Finally, the level of economic risks being assumed and the
functions performed by each party must be similar. Clearly, it
would be inappropriate to compare a related party transaction
where the affiliate engages solely in manufacturing a product
with a transaction in which the unrelated party not only
manufactures but also must market the product.
b. "Internal" Standards
To meet this set of standards, the contractual aspects of
the transactions being compared must be substantially similar in
all important aspects. The most obvious ones include the amount
and form of compensation for the transferred intangible. The
most common compensation form is a royalty determined as a
percentage of sales or quantity produced, but, as Appendix D
discusses, other forms are sometimes used. If the comparable
transaction contains accelerator or decelerator clauses under
which the royalty increases or decreases as sales increase, for
example, such clauses should appear in the related party
transaction. Other elements of a transaction can have a
significant effect on the income realized by unrelated parties to
a license or similar agreement. These elements must be
200 Rev. Rul. 87-71, 1987-2 C.B. 148,
201 See discussion supra Chapter 4.
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substantially similar in order for the unrelated party
transaction to be an exact comparable. For example, if the
unrelated party agreement provides for the licensee to receive a
specified level of technical assistance and training, the related
party transaction should contain similar rights. Similarly, if
one agreement calls for the licensee to perform significant
marketing or product development, while in the other the licensor
performs the marketing, the agreements lack internal
comparability.
3. Exact Comparables and Periodic Adjustments
A comparable that is exact at the outset of a transaction
may lose its exactness over time. There should therefore be two
requirements of continued use of the exact comparable over time.
First, the arrangements must be consistent in their provision for
options and other types of contingency clauses so that they
provide for substantially the same types and amounts of
adjustments for changing circumstances. Second, the comparables
will not remain exact over time unless related parties perform
these adjustments as unrelated parties do, under circumstances
that are comparable.
Is the concept of an exact comparable so rigid that the
results of related party and unrelated party agreements must be
the same? Consider a U.S. company that licenses an intangible to
two unrelated parties, one in Asia and one in Latin America. It
is reasonable to predict that the arrangements will be similar if
the economic environments are similar. However, it will probably
not be the case that the U.S. company will realize the same
income from the two transactions in every year. Business cycles,
for example, vary across locations over time. The Asian licensee
may have a very profitable experience when times are "lean" in
Latin America, or vice versa.
The standards for exact comparables should not require year-
by-year equality between the results of the unrelated party
arrangement and of the related party one if it is reasonable to
conclude that the long-term results will be comparable. Related
parties should not be required to exercise rights they might
have, if unrelated parties do not in fact exercise them.
4. The Role of Inexact Comparables
This section describes the appropriate role for unrelated
party transactions that cannot satisfy one or more of the
standards for exact comparables. Because of the unpredictable
outcomes that inexact comparables have caused in the past, one
might argue that they simply should not be used. However, the
data presented in Appendix A suggests that some continued use of
inexact comparables would be appropriate. The International
Examiners reported that they made some use of comparables in
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making transfer pricing adjustments 75 percent of the time.^°^
Although the reported use of comparables for transfers of
intangibles in general was lower, it was higher (76.5 percent)
for marketing intangibles.^" ^ The lEs did not report making
final determinations based solely on these comparables in all
these cases, but that they made some use of them. Clearly, in
practice, inexact comparable transactions provide significant
information, even with respect to transfers of intangible
property.
The problem, therefore, is not that inexact comparables are
useless or misleading. Rather, either they have been given too
much emphasis in many cases or inappropriate comparables have
been used. The proper conclusion is that it is appropriate to
make use of them, but that it is inappropriate to determine
transfer prices solely on the basis of inexact comparables. This
conclusion is fully consistent with the arm's length principle.
The arm's length approach requires that exact comparables, when
they are available, should determine transfer pricing allocations
of income. However, it does not follow that the same is true of
inexact comparables. That is, inexact comparables should be
resorted to only when exact comparables are unavailable.
Further, they should not be given priority over the alternative
method outlined in section C of this chapter in all cases.
5. Selection of appropriate Inexact Comparables
Once it is determined that an exact comparable does not
exist, how should inexact comparables be selected? The most
obvious point is that the external and internal standards
discussed previously should parallel those in the transaction at
issue as closely as possible. For example, if the unrelated
parties in the potential comparable operate in a very different
economic environment — if the market is much smaller or the
related parties carry on a much broader set of transactions --
then the comparable should not be used to justify the related
party arrangement. Similarly, if the intangible in the unrelated
party transaction is at a very different stage of development or
concerns a dissimilar product or service, then its use as a
comparable is inappropriate.
In more traditional terms, an unrelated party arrangement
should be used as an inexact comparable if the differences
between it and the related party transaction can be reflected by
a reasonable number of adjustments that have definite and
ascertainable effects on the terms of the arrangement. The
current regulations for section 482, although silent on this
2° 2 Appendix A, infra.
2°3 Id.
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issue in connection with transfers of intangible property,
discuss it quite carefully in connection with transfers of
tangible property. They mention that adjusting a sale for
differences in transportation costs or minor physical
modifications would probably be appropriate, but that an
adjustment for the presence or absence of a trademark would
not. 20*
This approach should be extended to transfers of intangible'
property. For example, unrelated party arrangements frequently
require the licensor to provide a specified amount of training or
expert assistance to the licensee for a brief period.2°^ It may
be possible to adjust a comparable that includes such a provision
by comparing it with an arrangement that does not, or that
provides for less assistance.
At the other extreme, consider an attempt to compare an
unrelated party license with a related party license when the
unrelated party licensee performs different functions than the
related party licensee. For example, the former may be
responsible for substantial marketing, while the latter may not.
It seems clear that the effect of this difference would not be
definite and ascertainable. Therefore, an adjustment for it
would be too speculative to be appropriate.
Similarly, intangibles differ in their fundamental
profitability. Attempting to compare a low-profit intangible to
a high-profit one by adjusting for this difference would clearly
be too speculative to be appropriate. Comparable transactions
involving intangibles that are likely to be of typical or average
profitability are therefore appropriate inexact comparables only
if the related party intangible under analysis is typical or
average.
The current regulations contain a list of twelve factors
which are essentially internal and external standards that might
be examined in order to determine whether an unrelated party
license is an appropriate inexact comparable. As many observers
have pointed out, however, it is difficult to derive useful
guidance from this list, because it does not discuss the
relative weights to be placed on the factors in a given
situation. For example, prospective profits to be realized from
the intangible appears late in the list, but after the 1986 Tax
Reform Act this factor must be given special consideration. In
contrast, the first listed item cites prevailing industry rates.
20* Treas. Reg. §1.482-2(e)(2) ( ii) .
2 5 See infra Appendix D for further discussion of
unrelated party licenses.
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which should not be relied upon unless the intangible being
transferred is demonstrably average, based on observable
indicators of profitability.
Another approach that provides a framework for use of
inexact comparables is "functional analysis." Although not
explicitly mentioned in the regulations, this procedure is
outlined in the IRS Manual^"* and has been found to be a useful
place to start in transfer pricing situations. In essence, the
goal of functional analysis is to identify the economic
activities actually undertaken or to be undertaken by the parties
in both the related party situation and unrelated party
situation. The most appropriate comparables may be chosen by
identifying the ones in which the unrelated parties carry on the
same major economic activities as the related parties. Section C
of this chapter examines functional analysis in the context of
the arm's length rate of return method. Functional analysis is
an equally valid approach for analyzing comparables on the basis
of the similarity between the economic activities performed.'' ° '
6. Use of Inexact Comparables And Periodic Adjustments
It is inappropriate to use inexact comparables to justify a
related party transaction merely by analyzing similarities at the
time of the initial transfer. For example, there may be valid
inexact comparables that justify the establishment of a related
party agreement with a fifteen percent royalty rate. These
comparables may further justify fixing this rate for two years.
Even if no adjustment were required during the first two years,
in year three the taxpayer may not continue to rely upon the
prior inexact comparables unless, after re-examination, use of
these comparables remains appropriate.
Suppose a significant change occurs during the term of a
license agreement. For example, suppose a taxpayer licenses a
product design to a related party. At the time of the transfer,
the taxpayer makes a good faith estimate that the product will be
a routine one, and will attain 10-25 percent of its market.
Based on this fact, the taxpayer gathers information on
comparable transactions (none of which can meet the standards
for an exact comparable). The information indicates that a
royalty rate of 10 percent of sales is appropriate. The
comparables contain varying duration and contingency clauses. In
2°' I.R.M. §600 et seq .
^°^ As Appendix D stresses, it is insufficient merely to
replicate a royalty rate in order to achieve a comparable
license. For example, the technological services provided by the
licensor may have a large impact on the profitability of the
license from the licensor's perspective.
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year three, the product design becomes uniquely popular and
gamers 95 percent of the market. Given this set of facts, the
inexact comparables previously used may no longer be used in year
three and succeeding years to justify the 10% related party
royalty rate.^"®
Although unlikely, the taxpayer may find inexact comparables
involving products with a 95 percent market share that
demonstrate that the 10 percent royalty rate is still
appropriate. More realistically, suppose that there are
comparables that show that products in the taxpayer's industry
with a 95 percent market share typically command a much higher
royalty, or, as may be more likely, that there are no comparables
for such a situation. In such case, the taxpayer must use the
arm's length return method outlined in section C below either to
justify the royalty rate previously set or to adjust the related
party arrangement to bring it into compliance with the results of
this new analysis.
C. An Arm ' s Length Return Method
The previous chapter discusses why a method that looks to
arm's length returns, as distinct from arm's length prices, is
appropriate. This section discusses how such a method should
operate. Although some of the terminology in this section may be
new, most of the techniques discussed in it are not. One of the
main arguments for the development of an arm's length return
method, in fact, is that taxpayers, the Service, and especially
the courts have found it necessary to use ad hoc and incompletely
developed versions of such a method in the past and will
undoubtedly continue to do so in the future. Therefore, the goal
of this discussion is to lay a foundation for this approach so
that it may be used to achieve more consistent and satisfactory
results.
1. Basic Arm's Length Return Method
a. General Description
Consider a U.S. company, Widgetco, that holds worldwide
patent rights to the widget, a high-tech light gathering device
that is expected to be a vital component in certain satellites
and scientific instrximents . Widgetco intends to exploit this
patent in the following way. A foreign affiliate will
manufacture the widgets, under license from Widgetco. Besides
utilizing the license, Widgetco and the affiliate will engage in
2 ° ^ There may be other cases where the taxpayer can
demonstrate an arm's length basis for continuing to use inexact
comparables. See discussion infra Chapter 8 regarding periodic
adjustments.
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the following transactions. Widgetco will sell various types of
microchips, seals and filters to the affiliate, which will also
buy some of these products from unrelated suppliers. The
affiliate will use these components to manufacture the widgets
and sell them to Widgetco, which will market and distribute them.
Widgetco maintains a research staff that developed the widget and
will continue to try to improve it.
It would be very difficult to depend purely on comparable
transactions, as traditionally defined, to establish the proper
allocation of income in this sort of "round trip" transfer-
pricing situation. There are three separate types of comparables
that would have to be found. The first is a set of prices for
the components the parent will sell to the affiliate. The second
is the royalty that the affiliate should pay to the parent under
the production license. The third is the transfer price for the
finished widgets. Although it may be possible to find exact
comparables for one of these types of transactions, such as the
purchase price of some of the components, it will in general be
impossible to find comparables for all three. Further, finding
an answer to only one aspect of the problem provides little help
in deciding the proper allocation of income between the related
parties.
Another approach would be to try to find one or more
comparable transactions in which a company contracts with an
unrelated party to manufacture a product similar to the widget.
It is likely that these transactions will not be good inexact
comparables. In general, the form, risks, and extent of
relationships in the related party case will at least appear to
be quite different from those in a contract manufacturer
transaction. Among other things, the foreign affiliate carries
raw material, work-in-process, and finished goods inventories
and should receive a normal market return on its activities that
reflects its investment in such assets and the moderate risk that
manufacturers using routine manufacturing processes bear with
respect to their investment in manufacturing facilities and
inventories. Using the terminology of the previous section, a
contract manufacturer transaction is likely to fail both the
external and internal standards for inexact comparables, because
both the types of transactions between the parties and the terms
of their agreements will differ. While comparables of this type
should not be discarded from all consideration (because this type
of comparable may provide useful information), it would be
improper to base a resolution of the transfer pricing issue
solely on such information.
An arm's length return approach would start from a different
perspective. It would seek to identify the assets and other
factors of production that will be used by the related parties
in the relevant line of business and would try to assign market
returns to them.
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The first step in this process is to perform a functional
analysis -- i.e. , to break down each line of business into its
component activities or functions. It should then be possible
to identify which of the functions utilize only factors of
production that can be measured and assigned market returns and
those which do not. In most cases, identifying functions with
measurable factors will lead to distinguishing between those
functions that make significant use of preexisting intangible
assets and those that do not. In Widgetco's case, Widgetco owns
several types of assets that are difficult to measure, including
the widget patent and other manufacturing intangibles, the
ongoing enterprise value of the research staff, and the marketing
intangibles. On the other hand, the foreign affiliate utilizes
measurable factors of production, assuming that the manufacturing
process is a routine one. Specifically, the affiliate employs
labor, plant, equipment, working capital, and what might be
called "routine" manufacturing intangibles — i.e. , know-how
related to efficiency in routine manufacturing processes that
most manufacturers develop through experience. Since it is
easier to evaluate the factors of production to be used by the
foreign affiliate, the market rate of return analysis will focus
on the affiliate. As the theoretical analysis in the previous
chapter demonstrates, focusing on the return of the affiliate in
this manner is a valid extension of the arm's length principle.
Next, income should be assigned to each of the functions
with measurable factors -- here the functions performed by the
affiliate. The reason for identifying measurable factors (and,
therefore, focusing on the affiliate) is that the functions that
employ measurable factors will probably be carried on by a wide
range of unrelated parties for which information will probably
be available regarding market returns earned by them. A market
return consistent with the returns of unrelated parties can be
assigned to each of the affiliate's functions since they all
employ measurable factors. Once returns are identified for all
of the affiliate's functions, the residual income from the line
of business is then allocated to Widgetco.
Assume, as stated, that the only function to be performed by
Widgetco's foreign affiliate is manufacturing and that this
function does not involve the significant use of intangible
property developed by the affiliate or purchased by it from
unrelated parties. Under the rate of return method, the assets
of the foreign affiliate would be divided into liquid working
capital and all other assets ( i.e. , the production assets). The
actual return on the liquid working capital will be identified
and allocated to the foreign affiliate. Rates of return on
production assets used in similar manufacturing activities of
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similar risk must be identified or estimated.^ ° ' Income will
then be allocated to the affiliate for its manufacturing activity
in an amount equal to the identified or estimated rate of return
as applied to its production assets. This rate of return would
include, by definition, a return on routine manufacturing
intangibles that manufacturers commonly possess as well as a
return for assuming normal business risks that manufacturers bear
with respect to their investment in manufacturing facilities and
inventories.2^° The residual- amount of income from the line of-
business is allocated to Widgetco.
The same allocation would be made to the foreign affiliate
if it sold its output to a second affiliate and not back to
Widgetco. In neither case would the foreign affiliate receive a
return for marketing its product.
b. Use of Arm's Length Information
There are two ways that arm's length information can be used
to allocate income to the activities of the Widgetco
manufacturing affiliate. The first method has been previously
described -- to identify the unrelated parties' rates of return
on assets utilized in a particular function, taking into account
only the non-liquid assets relevant to the function in the line
of business being examined. If satisfactory measures of the
unrelated parties' assets are available, it should be possible to
calculate an appropriate rate of return for each function and
apply it to the related party's assets utilized in that
function.
The second way to use the arm's length information is to
measure it against a yardstick other than rates of return on
assets. A common alternative is the ratio of income to operating
costs. For example, in the DuPont case,^^^ an expert witness.
Dr. Charles Berry, computed the ratio of gross income before
reduction by operating costs and interest to operating costs for
DISA, DuPont 's Swiss affiliate, and for a number of unrelated
parties performing similar functions. This analysis is useful to
measure returns on service activities and in other situations
where assets are difficult to measure consistently or, more
generally, where there is reason to believe that the
relationship between income and costs is more stable or easier to
measure than the relationship between income and assets. As is
2°' Because manufacturing is a broad category, the function
or activity would be defined more precisely. An example might be
"medium instrumentation fabrication, assembly, and testing,"
210 See discussion of risk infra section E,
211 See discussion supra Chapter 4.
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true with assets, it is important to consider the types of costs
and their relationships to income earned, not just the totals.
For example, some analysts have used the ratio of gross income to
"above the line" costs. This approach is suspect^ if the
unrelated parties incur proportionately larger amounts of "below-
the line" costs, such as advertising, than the "r-elated affiliate
incurs .
The use of both types- of -unrelated party information is
consistent with the fundamental goal of the basic arm's length" '
return method, which is to use information about unrelated
parties to determine the returns that would have been earned had
the related parties' activities been undertaken at arm's length.
Therefore, both approaches are potentially applicable depending
upon the availability of either type of information and the
appropriateness of using either type of information in the
particular circumstances.
c. Applicability of Basic Arm's Length Return Method
The basic arm's length return method should have wide, but
not universal, applicability in situations where exact or inexact
comparable transactions are not available. It will not be
sufficient alone, however, when both of the related parties own
preexisting and significant intangible assets that are vital to
the success of the project — for example, if Widgetco's foreign
affiliate actively markets the products it manufactures in a
manner that utilizes significant self -developed marketing
intangibles. In such cases, it will be difficult to find a set
of unrelated parties that possess the same type and amount of
intangible assets as the affiliate and are. thus able to perform •
the same activities. It will be difficult, therefore, to obtain
the arm's length information needed to assign a return to either
affiliate's activities.
This discussion is not meant to imply, however, that the
basic arm's length return method is to be avoided whenever an
affiliate possesses any amount of intangible assets. It is
unlikely, for example, that any manufacturing operation is so
simple that it does not involve the use of some intangibles. An
affiliate engaged only in manufacturing may employ a skilled
labor force, and the efforts expended in recruiting and training
it may create at least some amount of going concern type of
intangible. Further, the affiliate's experience in producing the
parent's designs may lead to the development of some amount of
know-how. These facts alone, however, should not prevent the
application of the basic method. The reason is that unrelated
parties performing similar activities will, in general, possess
these types of "routine" intangibles. Therefore, by measuring
the return on assets that unrelated parties earn for performing
similar activities and bearing similar risks, the basic method
will automatically capture the returns earned by these "routine"
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intangibles and will properly attribute them to the affiliate.
It is only when the affiliate owns some type of intangible that
is of major importance to the enterprise, and -which few unrelated
parties possess, that the basic method is insuff ici-ent standings-
alone to resolve the issue.
The basic arm's length return -method will probably be ^^
appropriate for most manufacturing affiliates. It should be
possible to observe the rates of return on assets or ratios of - .•
income to costs that are earned by unrelated parties performing •-
similar manufacturing activities involving similar risks and
amounts of routine intangibles. It Is possible to think of
exceptions, however. Consider a corporation that has assembled a
large and valuable team of engineers and skilled craftsmen within
a European subsidiary in order to develop or perfect a complex
manufacturing process. If no or few unrelated parties would be
capable of performing this development activity, the basic arm's
length return method will not be sufficient standing alone to
resolve the case.
Similarly, the basic method will be applicable to many
distribution and marketing affiliates. An affiliate that sets up
and maintains a distribution network undoubtedly possesses a
going concern intangible; an affiliate that markets products to
industrial customers by participating in trade shows and
maintaining a staff of salespersons undoubtedly possesses some
amount of know-how. However, it seems likely that these sorts of
activities are undertaken by unrelated parties that possess
similar amounts of going concern value and know-how. Therefore,
it should be possible to determine the arm's length returns on
assets for these activities, which will include the appropriate ■
returns to these "routine" intangibles. In other situations,
however, the basic method alone will not suffice.
2. Profit Split Addition to the Basic Arm's Length Return
Method
Although the basic arm's length return method should be
widely applicable, there are situations in which its use alone
will clearly be inadequate. A large multinational corporation
may have foreign subsidiaries that have research, marketing,
planning, manufacturing, and other divisions that are as large
and active as those of all but the biggest U.S. companies.
Therefore, these affiliates may perform complex functions, take
significant risks and own significant intangible assets equal to
those of the typical parent corporation. If so, the basic arm's
length return method would be impossible to apply because exact
or inexact comparables, or rates of returns, for these complex
functions are generally unavailable.
Consider Teachem, a U.S. company that is a world leader in
designing and producing educational toys. It serves its major
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overseas market. Western Europe, through a French sales
affiliate, Enseignerem. Teachem is planning to license a new set
of designs to Enseignerem, who will modify them-in minor ways,
such as translating the instructions and markings, »and who will
hire local contract manufacturers to produce them.- Enseignerem •»•
will utilize its own trademark and be responsible for all
aspects of marketing and distribution in Europe. It will decide
which of the toys to include in its line, set its own advertising
budget, and design campaigns to promote the new line and its
Enseignerem trademark. It also maintains a sales force -and
distribution network. Teachem maintains a research and testing
staff to develop new products. The affiliate does not.
Assume further that Teachem has a business policy of not
licensing its designs to unrelated parties. Exact comparables
will therefore be absent, and inexact comparables may be
difficult to find. How would an arm's length return approach be
applied to determine the appropriate royalty rate to be paid by
Enseignerem for the use of Teachem 's designs? The first step is
to identify the functions performed by the parent and the
subsidiary in the line of business in which the licensed designs
are used (the sale of new toy designs in the European market).
The parent should be allocated the returns on the basic product
designs, while the subsidiary is entitled to the returns to be v
earned by its trademarks, marketing efforts, and distribution
network, plus any intangibles related to the modifications.
The next step is to identify the functions that employ
measurable factors -- i.e. , activities that do not involve the
use of significant intangible assets. These activities should be
analyzed using the basic arm's length return method. -v
Enseignerem ' s distribution and manufacturing activities may be ~
examples. It should be possible to find unrelated parties that
perform these typea^of activities and incur similar business
risks. Thus, it should be possible to determine an arm's length
rates of return on assets (or income-to-costs ratio) for each
activity and apply the arm's length rate or ratio to the
appropriate related party factors. The resulting income should
then be allocated to the party performing the activity. In this
case, income attributable to distribution and manufacturing
activities would be allocated to Enseignerem. If the parent
corporation performs or is to perform routine activities
involving the line of business, they too should be analyzed using
the basic method.
These two steps will leave a quantity of income not yet
allocated and a set of activities involving significant
intangible assets not yet accounted for. The goal of the first
two steps is to isolate the income that is attributable to the
significant intangible assets owned by the corporate group as a
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whole and used in the line of business in question -- primarily
the designs ovmed by Teachem and the marketing intangibles
(including the trademark) owned by Enseignerem. --
The goal of the remaining step is to identify the --^
intangible income attributable to the relevant line of business -
and then split that income according to the relative value that
the marketplace would put on each party's significant- intangible
assets had they been employed by unrelated parties operating at
.arm's length. The intangible income is equal to the combined net
income from the line of business less the income allocated under
the prior steps to functions with measurable factors -- i.e., the
residual combined net income determined after applying the basic
rate of return method to activities with measurable factors of
the parties. In splitting this residual amount between the
related parties, it is not necessary to place a specific value on
each party's intangible assets, only a relative value. Of
course, it is easier to state this principle than to describe in
detail how it is to be applied in practice. In many cases, there
will be little or no unrelated party information that will be
useful in determining how the split would be determined in an
arm's length setting. Furthermore, the costs of developing
intangibles, even if known, may bear no relationship to value,
especially in the case of legally protected intangibles, and
generally should not be used to assign relative values to the
parties' intangible assets. Splitting the intangible income in
such cases will largely be a matter of judgment. There are two
possible sources of arm's length information, however.
First, it may be possible to find unrelated parties that
engage in similar activities and that .use similar intangibles, -a?-
The unrelated party transactions must be economically similar, of
course, including the level of economic risks assumed. It would
be inappropriate to use a profit split derived from a situation
in which the unrelated parties' intangibles were much less (or
more) profitable than those owned by the related parties.
Further, it would be inappropriate to compare the split derived
from a transaction in which an unrelated party conducted only
wholesale level marketing, for example, with a related party
situation in which an affiliate markets products to consumers.
These requirements resemble the standards discussed above for
inexact comparables. The analysis of unrelated party profit
splits should explain the relationship between the observed
profit splits and the overall profitability of the significant
intangibles involved with a reasonable degree of accuracy. It
is also necessary to analyze the functions that the unrelated
licensors and licensees perform and the risks that they bear.
Comments in this area should focus on how such an analysis can be
implemented.
Second, in some circumstances, a taxpayer may have arm's
length evidence of the value of its own or its affiliate's
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intangibles. For example, a taxpayer may have recently purchased
its affiliate and may have some basis for determining the value
of the intangible assets using the purchase price.
3 . Arm's Length Return Method and Periodic Adjustments ■ '■.
Issues involving periodic adjustments are easier to analyze
for the arm's-length return- method than for .the methods -involving
comparable transactions. Because the basic arm's length return
method looks to the factors of production used by the parties,^ •^'■
the income allocation should adjust as the factors change. Thus-,
as an affiliate's plant, equipment, and other measurable factors
change from the projections in the initial analysis, the income
allocated to them should change. Similarly, the profit split
percentage is intended to reflect the relative values of
significant intangible assets ovmed by the parties. When the
value of intangibles belonging to one of the parties has changed,
the percentage should be changed. For example, a dramatic
increase in sales may be due to either a recent product
improvement or an extensive marketing campaign, in which case
proportionately more profit should be assigned to the developing
or marketing affiliate, respectively.
These conclusions are not intended to imply, however, that
there must be year-by-year equality between the related parties'
incomes and the results of an ideal application of the method.
The prior discussion of long-run versus year-by-year results is
again relevant. For example, consider an independent firm that
uses only plant and equipment. Although it should earn the
market rate of return in the long run, it will, in general,
experience lower returns or even losses in "lean" times and -.«
higher returns at the other end of the business cycle. Periodic
adjustments will be required for significant changes in income.
Therefore, changes (either negative or positive) that are less
than significant may tend to even out in a long-term
equilibrium. The absence of a requirement for an adjustment over
time when insubstantial changes in income occur is a corollary of
the rule that de minimis adjustments will not be made. Chapter 8
discusses this issue, including reasons why explicit inter-year
set-offs would not be practicable, in more detail.
D. Priority And Coordination Among Methods
The previous sections of this chapter discussed two broad
approaches for analyzing transfers of intangible property: an
approach based on comparable transactions and one based on arm's
length returns to factors employed. Which is to be used in a
given situation? The answer is clear in one case. If an exact
comparable is present, it and only it should be used to determine
the allocation of income from the transfer. It follows from the
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definition of exactness that there can be no better evidence of
what unrelated parties operating at arm's length would have
done.
-Finding an exact comparable, however, can be -extremely
difficult. In the majority of cases, particularly contested
ones, the allocation of income will come from either the inexact
-comparable method or the-.arm's length return method. The facts -
and circumstances of each case should determine which method —
or methods -- should be used.
There are four basic types of cases. In the first, the
intangible for which a section 482 transfer price is being
determined is comparable, to those used by unrelated taxpayers
and each of the related parties is expected to employ significant
and complex intangibles. The inexact comparables method should
be chosen.
In the second case, the section 482 intangible is unique,
and the affiliate utilizing the intangible will engage in
functions that use only measurable factors of production and
routine amounts of intangibles. The basic arm's length return
method should be used.
In the third case, the section 482 intangible has many
competitors and the affiliate using the intangible will engage in
simpler kinds of functions. Both of the methods are potentially
applicable. Under the theory on which they are based, they
should yield similar results. This situation should, in
practice, be the easiest for the taxpayer to analyze and should
engender the least amount of controversy.
In the final case, the section 482 intangible is unique and
both of the related^parties own one or more significant
intangibles that will be used in exploiting it. This is the
hardest case. The profit-split version of the arm's length
return method must be used.
E. Risk-Bearing in Related Party Situations
Economic environments are full of uncertainty, and this fact
must be recognized in all methods of income allocation. In
general, in a related party transaction, the market reward for
taking risks must be allocated to the party truly at risk.
Companies take risks in all dealings in the marketplace, and
are rewarded for doing so. Some of this risk disappears in
related party transactions. The legislative history of the Tax
Reform Act of 1986 noted:
In addition, a parent corporation that transfers
potentially valuable property to its subsidiary is not faced
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with the same risks as if it were dealing with an unrelated
party. Its equity interest assures it of the ability
ultimately to obtain the benefit of future anticipated or
unanticipated profits, without regard to the price it
sets,2i2
How should risk be accounted for in related party
transactions? The riskiness of true economic activities gives -t
rise to greater returns in the marketplace; therefore, if one
part of an enterprise is inherently more risky than another, more
income should be allocated to it. This allocation should be
based on the risks arising out of the true economic activities
undertaken by the parts of the enterprise, not on mechanisms that
merely shift risks within the group.
This conclusion has implications for the proper application
of both the comparables approach and the arm's length return
approach. First, in searching for appropriate comparables, one
should look for situations in which an unrelated party contracted
to perform an economic activity that is about equal in riskiness
to the activity done by the affiliate; it would be inappropriate
to rely on comparables in which the unrelated party undertook a
significant risk of some kind not undertaken by the related
party. Likewise, in applying the arm's length rate of return
method, unrelated party rates of return should be used only if
they reflect similar levels of risk. But merely stating that
unrelated party transactions must bear the same level of risk as
the related party begs the question of what risks the related
party should be allowed to assume. It's necessary to decide
first what risks may be appropriately assumed by the related
parties, depending on the functions that each performs. Only ^'.
then is it possible to identify what unrelated party arrangements
are comparable so that comparable rates of return (or inexact
comparable transactions) can be determined.
Returning to the Widgetco example, the affiliate, as the
manufacturer, is at risk both with respect to its investment in
plant and equipment and with respect to inventories. The risk
with respect to plant and equipment will be significant only if
the facilities cannot be used for other purposes without
21? 1985 House Rep., supra n. 47, at 424 (1985). A line of
court cases not directly relevant to section 482 has reached a
similar conclusion. In Carnation and succeeding cases, members
of an affiliated group of corporations were denied deductions for
"insurance premium" payments to another member of the group that
insured predominantly risks of the group. The courts decided
that no true insurance was present, because there was no true
risk shifting between the parent and its affiliates. Carnation
Co. v. Comm'r , 71 T.C. 400 (1979), aff 'd , 640 F.2d 410 (9th Cir.
1980), cert, denied, 454 U.S. 965 (1981).
- 105 -
incurring significant additional costs. If there is risk that
'the product will not be successful because there is uncertainty
that the product will perform as anticipated or have the usages
anticipated, then that risk should be borne by Widgetco as owner
of the manufacturing intangible (the patent) and should not be "^
reflected in the affiliate's rate of return. The affiliate's
return should reflect only the -moderate level of risk borne by
manufacturers of products that are reasonably expected to ^chievfi
market acceptance. Likewise, if there is uncertainty that the ■>
product will be marketed successfully, then that marketing risk
also should not be borne by the affiliate but should probably be
shared in some fashion by the owner of the manufacturing
intangible and the marketer, depending upon the extent to which
anticipated profits from the enterprise are attributable to the
manufacturing intangibles or the marketing activities.
On the other hand, assume that the risk does not relate to
undue uncertainty regarding the anticipated performance or usage
of the product or the market acceptability of the product.
Assume, instead, that it is highly uncertain whether the product
can be produced cheaply enough to make the enterprise viable, or
that it is uncertain whether the manufacturing process will
produce the product with the same quality as prototypes produced
in the laboratory. These risks are risks inherent in the
manufacturing function and should probably be shared in some
fashion between the owner of the manufacturing intangible and the
manufacturing affiliate. If the manufacturing affiliate is
itself developing an efficient production process that attempts
to achieve low production costs or to assure consistency in
quality of output, then the affiliate should be allocated a
return that reflects a substantial portion of that risk being •««
borne by the manufacturing affiliate. (In such case, the
manufacturing affiliate would bring to bear significant
manufacturing process intangibles which would necessitate the
application of the profit split addition to the basic arm's
length return method. ) If, instead, the owner of the intangible
has also developed the production process without significant
contribution by the manufacturing affiliate, then a separate
manufacturing intangible related to the production process has
been created, and the owner of such intangible is entitled to an
arm's length return. The manufacturing affiliate's return should
not bear more than the moderate level of risk borne by
manufacturers of products that are reasonably expected to achieve
market acceptance.
F. Coordination with Other Aspects of Transfer Pricing
The purpose of this chapter is to provide a framework for
the development of new methods for allocating income from
intangible property. Therefore, methods for allocation of income
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in situations involving provision of services^ ^^ or transfers of
-tangible property^ ^* may appear at first glance to-be outside the
scope of the present discussion- However, the rules for
intangible property must be coordinated with the -rules for other
types of -■transactions between related parties for obvious
reasons. Transfers of tangible property and provision of
services frequently accompany a transfer of intangible property;
all three are of ten -bundled into a single economic -transaction.
■Further, if the rules relating to one type of transaction become
more or less favorable to taxpayers, then they will easily be
able to find ways to structure their transactions to take
advantage of the disparities.
It may be helpful to establish a priority for single
economic transactions that involve more than one type of
transfer. For example, licensing agreements often contain
clauses that require the licensor to provide training or other
services to the licensee. Further, transfers of tangible
property often involve intangibles, since the goods transferred
often depend for their value on embodied trademarks or patents.
In these cases, the basic allocation of income issue should be
settled under the rules to be developed for intangible property.
G. Conclusions and Recommendations
1. An approach incorporating two alternative methods for
determining transfer prices for intangibles would
achieve more appropriate allocations of income and
greater consistency in result.
2. The first method uses exact or inexact comparables «i«
when they exist.
a. An exact comparable is the same intangible
licensed to an unrelated parties, when the
circumstances surrounding it and the related party
transfer are similar. The price derived from this
method has priority over all others.
b. An inexact comparable is an intangible very
similar to the intangible transferred to a
related party, but not identical. Differences
must be definite and ascertainable. If the other
intangible, the contractual arrangements, or the
economic circumstances are too different, it may
not be used as a comparable.
213 Treas. Reg. §1.482-2(b).
21* Treas. Reg. §1.482-2(e).
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3. The second method uses an arm's length return analysis
instead of looking for a comparable transaction and
adopting that transfer price as the section 482
transfer price for the related party transfer.
a. The basic arm's length return approach applies
when one party to the transaction performs
... economic functions using measurable assets or ■•
other factors, but not using significant
intangibles of its own. The first step is to
break down the relevant line of business into its
component activities or functions and measure the
factors (generally assets) utilized by the party
performing the simpler set of functions. Income
attributable to those functions is determined by
identifying rates of return to assets or other
factors of unrelated entities performing similar
economic activities and assuming similar economic
risks, and applying a comparable rate of return to
the assets or other factors of the related party.
Any residual income is thereby effectively
assigned to the other party. The royalty rate or
other transfer price for intangibles utilized by
the related party must be set to achieve the
allocation of residual income to the other party.
b. When both parties perform complex economic
functions, bear significant economic risks, and
use significant self-developed intangibles, a
profit split analysis must be added to the basic
- rate of return method. Under the profit split •*
analysis, the combined net income from the line of
business must first be determined. The profit
split analysis assigns the residual net income,
determined after applying the basic rate of return
method to the measurable assets of the parties,
between the parties based upon the relative values
of the parties' unique intangibles.
4. While the standards for exact or inexact comparables
do not require year-by-year equality between results of
the unrelated party arrangements and related party
arrangements, unrelated party arrangements can lose
their comparability over time as the facts and
circumstances relevant to the standards for
comparability change. In such case an adjustment to
allocations of income may be necessary. Under the
arm's length return method, income allocations reflect
the functions performed by the parties and -- i.e. ,
they reflect the measurable factors of production and
the value of significant intangibles employed by the
parties in performing those functions. Therefore,
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income allocated to the related parties under the arm's
length return method will change as the functions
performed or the factors of production or value of
intangibles employed by the parties change,
5. Other than in the case of exact comparables, there
should be no priority among these methods. However,
each is designed to be utilized under- a specific set of
facts, so the underlying fact pattern should determine-
the method or methods to be used.
6. Risk should be accounted for under all methods
described in this chapter, since the market rewards
risk takers. However, the risk premium should be
attributed to the affiliate undertaking the economic
function in which the risk inheres.
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IV. COST SHARING ARRANGEMENTS
Preceding parts of this study have analyzed the proper
prices to be applied, or amount of income to be allocated, when
an intangible is transferred between related parties. Cost .• _—
sharing arrangements are an alternative method by which related
parties gan develop and exploit intangibles. The history of such
arrangements, their acceptance for tax purposes, and an outline --
of rules that should be followed for post-1986 cost sharing
arrangements are discussed in this part.
Chapter 12
HISTORY OF COST SHARING
A. Introduction
In general, a cost sharing arrangement is an agreement
between two or more persons to share the costs and risks of
research and development as they are incurred in exchange for a
specified interest in any property that is developed. Because
each participant "owns" specified rights to any intangibles
developed under the arrangement, no royalties are paid by the
participants for exploiting their rights to such intangibles.
The Conference Report accompanying the 1986 Act indicates that
Congress did not intend to preclude the use of bona fide research
and development cost sharing arrangements. However, Congress
expected the results produced under a bona fide cost sharing
arrangement to be consistent with results under the commensurate
with income standard.^ ^^
Cost sharing arrangements have long existed at arm's
length between unrelated parties. Typically, unrelated parties
pool their resources and expertise in a joint effort to develop a
specified product in exchange for a share of potential profits.
The Service has little experience with ordinary unrelated party
cost sharing arrangements because they are at arm's length and
normally do not have unusual tax consequences.^ ^ ^
In view of the limited information currently available on
both related and unrelated cost sharing agreements, the Service
and Treasury would appreciate receiving information from
taxpayers regarding their contractual arrangements and experience
with cost sharing.
2^5 1986 Conf. Rep., supra n. 2, at II-6.
216 See generally Rev. Rul . 56-543, 1956-2 C.B. 327,
revoked by Rev. Rul. 77-1, 1977-1 C.B. 161; see also Gen. Couns.
Mem, 36,531 (December 29, 1975).
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B. 1966 Proposed Section 482 Regulations
Proposed Treas. Reg. §l,482-2(d)(4), published on August 2,
1966, provided extensive rules for cost sharing arrangements.^^'
The proposed- regulations permitted any affiliate (other than ohe>
in the trade or business of producing intangible property) to
participate in the cost sharing arrangement, provided that the
intangible property was intended for use in connection with the"
.active conduct of the affiliate's business. The regulations
specifically authorized cost sharing arrangements for single
projects, but did not disqualify multiple projects or continuing
arrangements. The sharing of costs and risks was required to be
proportional to the anticipated benefits to be received by each
member from the arrangement. Cost sharing was required to be
based on sales, profits or other variable criteria.
The 1966 proposed regulations did not explicitly address the
"buy-in" question -- that is, the compensation to be paid to the
developer or owner of intangibles that are made available at the
time the arrangement commences. They did, however, require that
an arm's length amount be paid to the affiliate that provides
intangibles that substantially contribute to the arrangement.
Any required section 482 allocation for services provided by
other affiliates was also to be included as a cost of the
arrangement.
The proposed cost sharing regulations were ultimately
abandoned in favor of the simpler general requirements presently
contained in section 1 .482-2( d) ( 4 ) .
C. Current Regulations - ■
The current rules in section 1.482-2(d) (4 ) state that a cost
sharing agreement must be in writing and provide for the sharing
of costs and risks of developing intangible property in return
for a specified interest in the property that may be produced. A
bona fide cost sharing arrangement must reflect an effort in good
faith by the participants to bear their respective shares of all
costs and risks on an arm's length basis. The terms and
conditions must be comparable to those that would have been
adopted by unrelated parties in similar circumstances.^^ ^
21' 31 Fed. Reg. 10394 (1966).
21* Whether a particular cost sharing agreement meets the
requirements of section 482 is generally a factual question not
appropriate for a private letter ruling. There have been private
letter rulings regarding issues that are peripheral "to the
central question of whether a cost sharing agreement is bona
fide. However, none of these rulings concerned the
characteristics necessary for an agreement to be considered bona
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D. Foreign experience with cost sharing agreements
The 1979 OECD report on Transfer Pricing and Multinational
Enterprises ^ ^ ^ . stated that, although international cost sharing j»
agreements for research and development costs were not common,
some had recently been entered Into by large multinational
enterprises. The OECD report Indicated that, with- the exception
of the United States, none of its members had laws or regulations
pertaining specifically to cost sharing arrangements. A major
concern expressed by the OECD report was that the participants to
the arrangement be in a position to benefit from any intangibles
developed under the arrangement before the cost sharing payments
would be allowed as deductible expenses. The OECD report stated
that the United States did not require a profit mark-up for
research and development activities performed. The OECD report
reflected a consensus, however, that a profit mark-up would be
appropriate when research was performed at the specific request
of a member of the cost sharing group. There was also a
consensus that withholding taxes should not apply to cost sharing
payments when paid.
A few countries have specifically addressed cost sharing \
arrangements since publication of the OECD report. Germany has J
developed guidelines^ ^ ° for the use of cost sharing agreements in \
cases in which expenses for research and development can only be <
valued in the aggregate. Division of the costs must be based on '
the extent that each party actually benefits or expects to )
benefit from the arrangement. When determining costs Incurred,
no profit element is recognized for tax purposes. Appropriate I
costs to be shared may include a contribution to general and — *». ^
administrative costs. ■
fide under the current regulations. See Prlv. Ltr. Ruls.
8111103, 8002001, 8002014, and 7704079940A.
^^' OECD, Transfer Pricing and Multinational Enterprises ,
supra n. 158, at 55-62.
^^° The guidelines for cost sharing agreements are found
In paragraph 7 of the Gerroan Transfer Pricing Guidelines.
English and French translations of these guidelines are contained
in Raedler- Jacob, German Transfer Prlcing/Prlx de Transfert en
Allemagne (Kluwer Law and Taxation Publishers, Devender,
Netherlands, and Metzner, Frankfurt, Germany 1984). The
guidelines are also available in International Bureau t5T^ Fiscal
Documentation, Tax Treatment of Transfer Pricing (Amsterdam,
Netherlands 1987).
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E. Deficit Reduction Act of 1984
Section 367(d), enacted In 1984, provides that a transfer
of intangibles to foreign corporations in an exchange described
in section 351 or 361 is to be treated as a sale, with the ^
transferor being treated as receiving amounts that reasonably
reflect the amounts that would have been received under an
agreement providing for annual payments contingent on
productivity, use, or disposition of the. property. Such payments
are treated as reductions of the foreign entity's earnings and
profits and as U.S. source income to the U.S. recipient. The
"Blue Book" discussion of section 367(d) indicates that it is to
have no application to bona fide cost sharing arrangements.^ ^ ^
The Blue Book further recognized that it may be appropriate for
the Treasury Department to elaborate on the current cost sharing
rules to address problems with cost sharing arrangements.^ ^^
F. Cost Sharing under Section 936(h)
After 1982, the intangible income of a domestic corporation
qualifying for the possessions tax credit must be included in the
income of its U.S. shareholders, unless the possessions
corporation either elects the cost sharing method or elects the
50% of combined taxable income method, both of which are
contained in section 936(h). Under the section 936(h) cost
sharing election, the possessions corporation must pay its share
of the affiliated group's total research and development costs
based on the ratio of sales by the affiliated group of products
produced in the possession to total sales by the affiliated group
of all products. The cost sharing payment must be computed with
respect to "product areas" rather than single projects. "ProduciJ^
areas" are defined, in general, by reference to the three-digit
Standard Industrial Classification codes (SIC codes) promulgated
by the Commerce Department. Cost sharing payments made by the
possessions corporation are not treated as income to the
recipient but reduce otherwise allowable expenses.
A possessions corporation making the cost sharing election
is treated as owning the manufacturing intangibles utilized in
its business, and the income from such intangibles then becomes
eligible for the possessions tax credit. Pricing of products
between a possessions corporation electing the cost sharing
method and its domestic U.S» affiliates must still meet the
requirements of section 482, taking into account that the
possessions corporation is treated as owning the manufacturing
intangibles.
221 General Explanation of the DRA of 1984 , supra n. 143,
at 433.
2 2 2
Id,
- 113 -
Pursuant to an amendment made by the 1986 Act, a possession
corporation making the cost sharing election must pay the greater
of 110% of the pre-1986 statutory cost sharing amount or the
royalty required to be paid to the developer of -the intangibles u
under the commensurate with income standard.^ ^^ Given the
special circumstances in which the section 936(h) cost sharing ^
provisions apply and the 1986 Act changes, section 936(h) cost '
sharing arrangements do not provide much guidance with regard ta^
the appropriate requirements for other cost sharing
arrangements .
223 Section 936( h ) ( 5 ) ( C) ( i ) ( I ) , as amended by
§1231(a)(l)(A), Pub. L. No. 99-514, 100 Stat. 2085 (1986)
- 114 -
Chapter 13
COST SHARING AFTER THE TAX REFORM ACT OF 1986
A, Introduction
The Conference Report to the 1986 Act states "that, while
Congress intends to permit cost sharing agreements, -^^^ - it -expects
-cost sharing arrangements to produce results consistent with the
purposes of the commensurate with income standard in section 482
-- i.e. , that "the income allocated among the parties reasonably
reflect the actual economic activity undertaken by each." The
Committee Report also emphasized three potential problems that
should be addressed in any revision of section 1 .482-2( d) (4 ) .
The first problem is selective inclusion in the arrangement
of high profit intangibles. The Report states:
Under a bona fide cost sharing arrangement, the cost sharer
would be expected to bear its portion of all research and
development costs, on successful as well as unsuccessful
products within an appropriate product area, and the cost of
research and development at all relevant development stages
would be included.^ ^^
The second issue concerns the basis on which contributions
are to be measured. The Report states:
In order for cost-sharing arrangements to produce results
consistent with changes made by the Act to royalty
arrangements, it is envisioned that the allocation of RfiiD ■ -^
cost-sharing arrangements generally be proportionate to
profit as determined before research and development.^^*
The third specific Congressional concern relates to the
"buy-in" issue. The Report states:
In addition, to the extent, if any, that one party is
actually contributing funds toward research and development
at a significantly earlier point in time, or is otherwise
22< 1986 Conf. Rep., supra n. 2, at 11-638.
225 Id.
Id.
2 2 6
- 115 -
effectively putting its funds at risk to a greater extent
than the other, it would be expected that an appropriate
return would be required to such party to effectively
reflect its investment.^ ^ '
This chapter examines these and other issues that have
arisen with regard to the requirements for a bona fide cost
sharing arrangement after the Tax Reform Act of 1986. It should
be made clear at the outset that, if an arrangement is not bona
fide, any payments made under the cost sharing agreement will be
considered as offsets to the arm's length price that should have
been paid for the intangibles. While section 1 .482-2( d) (4 )
limits adjustments by the Service in the context of cost sharing
arrangements to an adjustment of contributions paid, this
regulation presupposes that the arrangement is bona fide. If the
arrangement is not bona fide, normal arm's length standards would
apply, including the commensurate with income standard.
B. Products Covered
In section 936(h), product area research is defined
generally by reference to the three-digit Standard Industrial
Classification (SIC) codes, meaning that the section 936(h) cost
sharing arrangement covers research and development costs over a
very broad product area.^^® As described above, the legislative
history to the 1986 Act contemplates that a section 482 cost
sharing arrangement should cover all research and development
costs within an "appropriate product area." The approach in
section 936 and in the 1986 Act legislative history contrasts to
the proposed 1966 regulations. Cost sharing arrangements
described in the 1966 proposed regulations could cover a single -t-.
project, although multi -project or product area cost sharing
agreements were not prohibited.
As discussed in section C below, broad product area cost
sharing arrangements raise the issue of whether the potential
benefits are proportionate to the participants' cost sharing
payments. This issue is of particular concern in cost sharing
arrangements of foreign-owned multinational groups if U.S.
persons are participants, since cost sharing payments made by
U.S. participants are deductible for U.S. tax purposes.^ ^'
227 Id.
228 Section 936(h) ( 5 ) ( C) ( i ) ( I )
22 9 Another potential abuse may arise in the context of a
domestic affiliate that is a co-developer of the IntangTble, or
otherwise participates in a de facto cost sharing arrangement.
In such cases, the foreign entity may try to avoid the
characterization of a cost sharing arrangement in order to
- 116 -
•On- the other hand, single product arrangements present the
potential that cost sharing may be employed solely for high
profit potential intangibles, such that foreign affiliates of
U.S. multdLnational groups acquire the rights to vsuch intangibles
without bearing the cost of research related to low profit
potential intangibles and unsuccessful research.- - The incentive '
to include selectively only high profit potential intangibles in
a cost sharing arrangement is most acute when tax haven entities
are the primary or predominate participants in the
arrangement . ^ ^ °
Three-digit SIC code product areas would seem to be the
appropriate scope of most cost sharing arrangements. Both the
Service or the taxpayer should be permitted to demonstrate,
however, that a narrower or broader agreement is more
appropriate o Taxpayers choosing a narrower agreement would need
to show that the agreement is not merely an attempt to shift
profits from successful research areas while leaving expenses of
unsuccessful or less successful areas to be absorbed by the U.S.
or higher tax affiliates. For example, some members of a
multinational food and beverage group might be interested in
research and development to develop a multi-purpose artificial
sweetener, yet their respective food and beverage product lines
might be sufficiently diverse (or might be products for which
research and development is not necessary) that a single product
agreement would be appropriate. Taxpayers choosing a broader
agreement would need, to show that the agreement is not being used
to charge U.S. affiliates or other participants for research and
development without reasonable prospect of benefit. From the
Service's perspective, a product area that is broader or narrower,
than three-digit SIC codes may be necessary to avoid these
distortions.
C. Cost Shares and Benefits
Underlying all of the problems discussed in the legislative
history of the 1986 Act in relation to cost sharing arrangements
is the fundamental principle that the costs borne by each of the
participants should be proportionate to the reasonably
anticipated benefits to be received over time by each participant
from exploiting intangibles developed under the cost sharing
arrangement. This cost share/benefit principle has several
facets, including the appropriate product area to be covered
extract royalties from the domestic affiliate, particularly where
the withholding tax on the royalties is reduced by a tax treaty
and the royalty income is not taxed or lightly taxed by'^he
foreign Jurisdiction.
2 3
See Lilly , supra n. 57, at 1150,
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(discussed in section B above), definition of costs to be covered
(discussed in section D below), and the measurement of
anticipated benefits and several other issues discussed below.
1. Assignment of exclusive geographic rights . In general,-
the computation of cost shares should reflect a good faith effort
to measure reasonably anticipated benefits to be derived from the
arrangement. While it is dif-ficult under the .best of
circumstances to predict what benefits each of the participants "•
-will derive, it is virtually impossible to do so unless the
participants are assigned specific exclusive geographic rights to
intangibles developed under the arrangement. Specific assignment
of rights could take the form of assigning the rights to
manufacturing intangibles relating to products to be sold in the
United States to a U.S. affiliate, rights related to European
markets to an Irish affiliate, rights related to Middle Eastern
and Pacific rim markets to a Singapore affiliate, etc. In such
case, the U.S. affiliate would derive the income attributable to
the manufacturing intangibles developed under the arrangement
with respect to any sales in U.S. markets regardless of whether
ultimately the U.S. affiliate is manufacturing the products sold
in U.S. markets. (As discussed below, however, the participants ;
must be those expected to exploit the intangibles by performing :
the manufacturing function themselves. ) i
Alternatively, exclusive worldwide rights to different types
of intangibles developed under the arrangement could be assigned '
to particular participants. This latter type of arrangement
would warrant special scrutiny to assure that the cost shares !
reflect reasonably anticipated benefits.^ ^^ Moreover, if I
research activities are not common to the various types of - -af* |
intangibles produced under the arrangement, then the research ^* |
related to each type of intangible should be charged to the i
specific affiliate that will receive the rights to that type of '
intangible. This is particularly true of arrangements where one
of the parties produces components. The Service and Treasury <
would welcome comments on this topic. In short, such research i
activities are not the proper subject of a cost sharing \
arrangement.
For various reasons, including consistency with longstanding
section 367(a) policy, U.S. geographic rights should never be
permitted to be assigned under a cost sharing arrangement to a
foreign person if either: (1) the participants are part of a
U.S. owned multinational group; (2) a significant portion of the
research is performed in the United States; or (3) any U.S.
person participates in the arrangement. Accordingly, U.S. rights
could be acquired by a foreign person only in the case of a
22^ As discussed in the next paragraph, rights to exploit
an intangible in the U.S. must belong to a U.S. affiliate.
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foreign-owned multinational group that conducts the research
overseas and does not include any U.S. affiliates as a
participant in the arrangement.
• 2. Overly broad agreements . The principle that cost shares
be proportionate over time to the reasonably anticipated benefits
may affect the issue of whether cost sharing arrangements are
.. overly broad in terms of the products covered or the affiliates
participating in the agreement. For instance, a manufacturing
conglomerate makes widgets and gadgets. An overall cost sharing
agreement for research and development may be inappropriate if a
particular affiliate does not make both widgets and gadgets. If
a disproportionate amount of research and development relates to
widgets but affiliate A manufactures only gadgets, affiliate A
would be subsidizing the research for the widget manufacturers.
Although every participant in a cost sharing agreement should not
be required to benefit from every intangible that may be
produced, cost shares should be proportionate to the reasonably
anticipated benefits. It may be necessary, therefore, either to
have separate cost sharing agreements for widget and gadget
research, to adjust affiliate A's cost share to reflect the costs
related to gadget research, or to exclude affiliate A from the
cost sharing arrangement.^ ^ ^
3. Direct exploitation of intangibles by participants . The
cost share/benefit principle may otherwise affect who may
participate in a cost sharing arrangement. In general, the
benefit to be derived under a cost sharing arrangement is the
right to use a developed intangible in the manufacture of a
product. Therefore, the participant must be in a position to
2^2 The exclusion of affiliate A from the cost sharing
arrangement raises the question of which of the other
participants should pay for research related to intangibles that
may be used by affiliate A. For various reasons, not all
affiliates that anticipate using the intangibles developed under
the cost sharing agreement may actually participate in the
arrangement. For example, there may be reason to exclude a
particular affiliate that manufactures only certain types of
products and therefore will use only certain types of intangibles
developed under the arrangement. Alternatively, the arrangement
may not be recognized under foreign law for tax purposes, such
that a deduction for cost sharing payments would be denied. In
such cases, some affiliate must fund research for ^intangible
rights to be used in manufacturing by the nonparticipants. While
there is no clear answer, it seems appropriate that the affiliate
that performs the research should fund and receive the residual righ
- 119 -
exploit the intangible in the manufacture of products.^^^ It is
not necessary that all participants be capable of manufacture at
the time costs are being incurred, so long as it is reasonably
anticipated that the participants will be capable of manufacture
once the intangibles are developed and will use intangibles
developed under the arrangement in the manufacture of ■ ^■
products.^ ^*
4. Measurement of anticipated benefits . In order to
determine whether cost shares are proportionate to reasonably
anticipated benefits, it is necessary to measure the anticipated
benefits. Obviously there has to be some prediction, rough
though it may be, of the kinds of intangibles likely to be
produced and the relative proportion of units that will be
produced and sold under the rights of each participant. In many
cases, estimated units of production may be an appropriate
measure of benefit assuming that there is a uniform unit of
production that can be used as a measuring device. If there is
no uniform unit of -production, then sales value may be an
appropriate measure, if measured at the same level of production
^^^ As a roughly analogous requirement, the 1966
regulations required that participants use the intangibles
developed under the cost sharing arrangement in the active
conduct of their trade or business. Prop. Treas. Reg. §1.482-
2(d)(4)(ii)(b), 31 Fed. Reg. 10,394 (1966). The 1966 regulations
would also have excluded as participants companies in the trade
or business of performing research for others. This latter
exclusion seems unnecessary so long as the affiliate that
performs the research and- development funds an appropriate •*"
portion of the research and development costs and is capable of '"*
using the intangible rights that it acquires under the agreement
in the manufacture of products.
^^* Expectations will not always prove true, and in some
situations the participant that acquires certain rights to
intangibles developed under the cost sharing agreement will not
ultimately directly exploit those rights. For example, assume
that a Dutch affiliate acquires the European rights to
intangibles developed under the arrangement with the anticipation
of manufacturing products for European markets in Ireland. It
later appears that it will be necessary for various reasons to
have a locally incorporated entity manufacture in Germany
products to be sold in the German market. Unless the German
rights to the intangible are transferred in a contribution to
capital or other tax free transaction, the German rights would
have to be licensed or sold to the German affiliate. In either
case the intangible would be subject to section 482 anrJ^
generally, the subpart F provisions would treat the resulting
royalty or sales income as foreign personal holding company
income includible in subpart F income.
- 120 -
or distribution for all participants. As stated in section A
-above, however^ the Conference Eeport anticipated that cost
shares be proportionate to profit as determined before research
and development. Given the legislative history, therefore,
neither units of production nor sales would be an appropriate
measure if it" were apparent (or became apparent during the course
of the agreement) that profitability differed substantially with
respect to various participants' rights. This would be true, for
example, in situations in which geographic markets differ -
significantly in terms of production costs, market barriers, or
other factors that bear significantly on profitability. In such
cases, estimated gross profit or net profit may have to be used,
or some adjustments may have to be made to cost shares determined
on the basis of units of production or sales.
It is not realistic, however, to expect taxpayers in most
instances to be able to estimate gross or net profit margins from
estimated sales. Even estimates of units produced or sales
value probably would be imprecise. It may be that a cost sharing
agreement should not be recognized if units of production or
sales are not appropriate measures and gross or net margins are
extremely difficult to estimate. In such cases, the
relationship between cost shares and anticipated benefits may
simply be too tenuous.
5. Periodic adjustments . The language in the legislative
history that the results of cost sharing arrangements be
consistent with changes made by the 1986 Act to royalty
arrangements has one other obvious implication. The cost shares
should be adjusted periodically, on a prospective basis, to
reflect changes in the estimates of relative benefits, including*""
a change in the- measurement standard if that becomes appropriated*"
In any event there is always a risk that the cost sharing
agreement could subsequently be rejected as a bona fide
arrangement if the estimates of benefits derived under the
arrangement proved to be so substantially disproportionate to the
cost shares that the estimates of benefits cannot be considered
to have been made in good faith. Periodic adjustments to the'
cost sharing arrangement would reduce that risk.
D. Costs To Be Shared
In general, the costs to be shared should include all direct
and indirect costs of the research and development undertaken as
part of the arrangement. Direct costs would include expenses for
salaries, research materials, and facilities. However, there
should be a limitation on the annual inclusion of costs for
depreciable assets that is consistent with U.S. tax accounting
principles- Otherwise, deductions for outbound paymen'ts- may be
overstated. Indirect costs should include a portion of overall
corporate management expense and overall interest expense that is
allocated and apportioned to research and development activities
- 121 -
in a manner consistent with U.S. expense allocation principles.
-The- costs to be reimbursed should be net of any charges for
research undertaken on specific request or for any government
subsidies granted.^ ^^
E. Buy-in requirements
As previously stated, the legislative history to -the 1986 "
Act states that a party to a cost sharing arrangement that has
contributed funds or incurred risks for development of
intangibles at an earlier stage must be appropriately compensated
by the other participants -- hence the requirement for a buy-in
payment. One of the primary reasons for adopting cost sharing
provisions is to avoid the necessity of valuing intangibles.
Yet, if there are intangibles that are not fully developed that
relate to the research to be conducted under the cost sharing
arrangement, it is necessary to value them in order to determine
an appropriate buy-in payment.
There are three basic types of intangibles subject to the
buy-in requirement. A participant may ovm preexisting
intangibles at various stages of development that will become
subject to the arrangement. A company may also conduct basic
research not associated with any product. Finally, there may be
a going concern value associated with a participant's research
facilities and capabilities that will be utilized.
Fully developed intangibles command a royalty to the extent
used by other participants and are generally not appropriately
incorporated into a cost sharing arrangement. Thus, royalties
for preexisting developed intangibles may not be included in the^
buy-in payment, but instead are subject to the general rules of '*"
the commensurate with income standard. Because a subsequent
substantial deviation in the income stream from the intangible
might require an adjustment, it is important to identify
separately the income stream and royalties related to preexisting
developed intangibles. In many situations, research is
performed with respect to preexisting intangibles in order to'
improve the preexisting intangibles (improved software, for
2^' It is generally expected that there will not be a
profit element in cost sharing agreements. A profit should be
required, however, for research performed at the specific request
of a group member or a for a person outside the arrangement
group. OECD, Transfer Pricing and Multinational Enterprises ,
supra n. 158, at p. 119. In either case, the amount received
should reduce the costs to be shared. One item that should not
be included in the costs to be shared among the partic^fpsnts is
the buy-in cost of transferring intangibles from the party by
whom they were developed to the other participants. This general
subject is discussed in section E below.
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example) or to develop the next generation of intangibles. The
ir«qu±rement -f or ~an adjustment to the royalty paid for the
intangible would not apply if the intangible is enhanced in value
solely as a result of research undertaken after inception of the
cost sharing arrangement .
The buy-in payment should reflect the full fair market value
of all intangibles utilized in the arrangement ^nd not merely -'
costs incurred to date.. To permit a buy-in based on' cost would
be inconsistent with the provisions of section 367(d) which
effectively precluded the tax-free transfer of intangibles and,
by implication, the transfer of intangibles at cost.^^^ The buy-
in payment could take the form of lump sum or periodic payments
spread over the average life expectancy of contributed
intangibles -- perhaps on a declining basis since intangibles
generally have greater value in the earlier stages of their life
cycle. Obviously, periodic payments should reflect the time
value benefit of not making a lump sum payment at the inception
of the agreement. --
A "buy-out" occurs when a participant withdraws from a cost
sharing arrangement. Having funded a portion of research and
development prior to withdrawal, that person owns a share of
whatever the agreement has borne to date and must be compensated
by the other participants for the value of what the arrangement
has produced to date and not merely reimbursed for costs incurred
to date.
A "secondary buy-in" is required when new members are
admitted after a cost sharing agreement is in place. If a new
member is acquiring a portion of the geographic rights of one of
the original participants, any buy-in amount should be paid to ■"**
the affiliate whose geographic rights are being reduced. Once
again, in order for.-the buy-in to be arm's length, any new member
must compensate the original participants in a manner similar to
the original buy-in computation, but based upon current values
and not merely costs incurred to date.
F. Marketing Intangibles
The 1986 amendment to section 482 provides that the term
"intangible property" shall have the same meaning as in section
936(h)(3)(B). The section 936 definition of intangible property
includes marketing intangibles. This does not mean, however,
23^ The legislative history of the 1984 Act states that
the provisions of section 367(d) can be avoided by selling
intangibles subject to the application of section -482- jfc«p» the
sale. S. Rep. No. 169, 98th Cong., 2nd Sess., vol. 1 at 368
(1984). The legislative history did not contemplate that a
transfer at cost would avoid the application of section 367(d)
- 123 -
that marketing intangibles are necessarily the proper subject of
, ^ ._ ,.cost ♦sharing »xules developed-with manufacturing intangibles in
mind.
In general, marketing costs yield a present benefit (even if
also a future benefit) and, therefore, are currently deductible
expenses for which a charge must be made under the services
provisions of the section 482 regulations if the benefit
. therefrom accrues to a related person. ^ 3 "^ (Research expenses ' -
related to manufacturing intangibles generally do not yield
present benefits but, nevertheless, are currently deductible
pursuant to the special provisions of section 174. ) In the
context of marketing expenses, the services regulations under
section 482 presently serve the same function as would rules
governing cost sharing arrangements in identifying the potential
beneficiaries of a marketing expense and requiring an appropriate
charge (albeit with a profit element in certain cases). There
seems to be no need for an additional regime to deal with the tax
treatment of cost sharing arrangements related to marketing
expenses. Comment is requested, however, concerning any
situations which are believed not to be covered by the section
482 services regulations or any perceived problems which arise
under those regulations as they affect marketing expenses.
G. Character of Cost Sharing Payments
Under section 936(h), the amount of any required cost
sharing payment is not treated as income of the recipient, but
instead reduces the amount of deductions otherwise allowable. ^ ^ '
More generally, when expenditures are made with the expectation
of reimbursement, they are treated as loans, and therefore the "
reimbursement does not constitute gross income -to the '*"
recipient.^^ ' Accordingly, cost sharing payments are not income
to the recipient but, instead, reduce costs which are otherwise
deductible in computing taxable income and earnings and profits.
Since cost sharing payments are not gross income to the
recipient, no U.S. withholding tax would be imposed on outbound
cost sharing payments made by a U.S. person to a foreign person.
Characterizing cost sharing payments in this manner also
reduces the amount of research and development expenses of the
entity performing the research that are subject to allocation
under the rules of section 1.861-8 and increases the amount
subject to allocation by the participants making the cost
237 Treas. Reg. §1 .482-2(b) ( 2) .
238 Section 936( h ) ( 5 ) ( C) ( i ) ( IV ) ( a ) ; Treas. Reg. ■f^936-
6(a)(5).
23 9 Boccardo v. U.S. , 12 CI. Ct. 184 (1987).
- 124 -
I
sharing payments . ^ ^ ° Furtheirmore , since the payments received by
the 'entity performing the research will not constitute income,
payments received by a U.S. entity from foreign affiliates are
not foreign source income to the U.S. entity.
For purposes of calculating the credit allowable under -r
section 41 for research expenditures, members of a commonly - --- •
controlled group of corporations may disregard intercompany *
■reimbursements for research expenditures.^"*^ This Tule treats -a---
U.S. company that actually performs U.S. situs research as
incurring 100 percent of the research expenses for purposes of
calculating the research credit, even if the U.S. company is
reimbursed for a portion of those expenses pursuant to a section
482 cost sharing arrangement.
One group of taxpayers has suggested that the regulations
should allow a cost sharer to denominate its rights under a cost
sharing arrangement as a geographically exclusive, no-royalty,
perpetual license if a license is required to obtain local
country tax benefits or if the parent would be in a better
position to protect against infringement than the subsidiary. If
under U.S. law, the participant is clearly the beneficial owner
of intangibles developed under the cost sharing arrangement, then
labeling its interest as a "license" will not change the
characterization for U.S. tax purposes, even if legal title to
the rights are held by its parent serving as nominee owner of
such rights. Therefore, whatever label is applied to the
arrangement for foreign law purposes generally would not affect
its U.S. tax treatment unless the label affects substantive legal
rights relating to the intangible.
2<o Section 1.861-8 sets out rules for allocating and
apportioning deductions between U.S. and foreign source gross
income. A special allocation rule gives companies the right to
allocate fewer U.S. research and development expenses to foreign
source income, even though the income generated by the expenses
is foreign source. Treas. Reg. §1 . 861-8( e ) ( 3 ) (B ) ( ii ) . Under' the
1986 Act, 50 percent of all amounts allowable as a deduction for
qualified domestic research and experimental expenditures is
apportioned to income from sources within the United States, with
only the remaining 50 percent apportioned on the basis of gross
sales or gross income of companies benefitting from the research
and development. This special provision applies only to expenses
incurred in tax years after August 1, 1986, and on or before
August 1, 1987. §1216, P.L. 99-514, 100 Stat. 2085 (1986).
Provisions similar in concept are currently under consideration
in Congress.
2<i Treas, Reg. §1.44F-6(e); Priv. Ltr. Rul. 8643006
(July 23,1986).
- 125 -
H . Possessions Corporations ^.^
The cost sharing payment made by a possessions corporation
pursuant to the special cost sharing election under section
936(h)(5)(I) must be determined under those rules and not under a
contractual cost sharing arrangement that -would -otherwise govern
the charges incurred by the participants. Indeed, the statute
and regulations explicitly provide that the .section 936(h)- cost-
sharing payment shall not be reduced by a contractual cost
sharing payment.^* ^ Under section 936(h), the cost sharing
payment by the possessions corporation must equal the greater of
the amount required under the new commensurate with income
standard or 110% of the pre-1985 Act statutory cost sharing
amount. Under the commensurate with income standard, the cost
sharing amount must at least equal the fair market royalty which
would have to be paid to the developer if the manufacturing
intangibles had been licensed (even in cases in which the
intangible had previously been transferred in a section 351
exchange) .
The amount paid under section 936(h) entitles the
possessions corporation to be treated as the owner of |
manufacturing intangibles previously developed by its U.S.
affiliates. The fact that a possessions corporation has entered
into a cost sharing arrangement for the development of future
intangibles and is paying a lesser amount under that arrangement
does not affect the amount required under the section 936(h) cost
sharing election. Indeed, since the section 936(h) cost sharing
payment is compensation for intangibles previously developed and '
the section 482 cost sharing payment made pursuant to the j
contractual cost sharing agreement is for the cost of developing"' ;
new intangibles, both amounts appropriately must be paid I
initially — one by^. statutory election and the second pursuant to j
the contractual arrangement. It might be argued that, once '
intangibles are developed under the section 482 cost sharing ]
arrangement, the possessions corporation's section 936 cost j
sharing payment should be reduced so that the possessions ;
corporation does not pay a second time for that intangible. The
statute, however, precludes that result.
I . Administrative requirements
Taxpayers seeking to enter into cost sharing arrangements
should be required to make a formal election and to document the
specifics of the agreement contemporaneously. Any U.S.
participant should be required to include a copy of the agreement
with its first return filed subsequent to the agreement's
effective date. Taxpayers making the election would -agree to
^*^ Section 936(h)(5)(c)(i)(I); Treas. Reg. §1 . 936-6( a ) ( 3 )
- 126 -
produce, in English and in the United States, the records of
foreign participants necessary to verify the computation and
appropriateness of the respective cost shares within 60 days of a
request by the Service. These records would include
identification of the SIC code or other basis used to determine
products covered by the agreement, and summary information
concerning sales, gross margins, and net income derived with
respect to such products. The House Report accompanying the 1986
Act suggests -that the Service should require similar records^ to —
be kept and produced under the authority of section 6001 for
section 936(h) cost sharing agreements.^* ^
J. Transitional Issues for Existing Cost Sharing Agreements
It is unlikely that there will be preexisting cost sharing
agreements that will meet all of the standards described above.
If such agreements are not recognized, the Service and taxpayers
will encounter significant problems in determining ownership of
preexisting intangibles and the treatment of the payments that
have been made pursuant to the preexisting agreements. Some
type of grandfather treatment would therefore appear to be
appropriate. One possibility would be to permit any cost sharing
agreement that conforms to the requirements of the existing
regulations, and that has been in existence for more than 5 years
prior to 1987, to be recognized fully if conformed within a
certain period after the promulgation of the new rules with
respect to matters other than the buy-ins that occurred prior to
June 6, 1984 (the effective date of section 367(d)). If the
cost sharing agreement has been in effect for less than 5 years
and the agreement does not conform substantially to the new
rules, then the old agreement would not be recognized. If a new.
agreement that conforms to the new rules is adopted, then all ■"'
payments pursuant to the old agreement would be taken into
account as an adjustment to any required buy-in payments
relating to the new agreement.^**
K. Conclusions and Recommendations
1. Congress intended to permit cost sharing arrangements
if they produce results consistent with the
commensurate with income standard in section 482.
2*3 1985 House Rep., supra n. 47, at 418-419.
^** This approach is generally consistent with the cost
sharing regulations published in 1968, which permitted"?^re-
existing cost sharing agreements to be modified within 90 days of
publication of the section 482 regulations. Treas. Reg. §1.482-
2(d)(4).
- 127 -
2. Three-digit SIC code product areas seem to be the
. . appropriate scope for most cost sharing arrangements.
Both the Service and the taxpayer should be permitted
to demonstrate, however, that a narrower or broader
agreement is more appropriate.
3. The fundamental principle underlying the concerns
identified in the legislative history of the 1986 Act ._
with respect to cost sharing is -that costs borne by
each of the participants must be proportionate to the
reasonably anticipated benefits to be received over
time by the participants from exploiting intangibles
developed under a cost sharing arrangement. This
principle has several implications.
a. In order for taxpayers to make a good faith effort
to predict anticipated benefits, it is essential
that the participants be assigned specific and
exclusive geographic rights to intangibles
developed under the arrangement. U.S. geographic
rights generally should not be permitted to be
assigned to a foreign person.
b. Cost sharing arrangements may be overly broad in
terms of products covered or affiliates
participating in the agreement if some
participants would utilize only a narrow range of
intangibles developed under the agreement.
c. Since the benefit to be derived under a cost
sharing arrangement is the right to use developed -
intangibles in the manufacture of a product, "^
participants must generally be capable of
manufacturing and using developed intangibles in
the manufacture of products.
d. In estimating anticipated benefits, units of
production or sales value generally would be ah
acceptable unit of measure unless profitability
would reasonably be expected to differ
significantly with respect to various
participants' rights. In the latter instance,
some adjustments must be made, or some other
standard of measurement utilized, to reflect more
accurately the reasonably anticipated benefits to
be derived by the participants.
e. Cost shares should be adjusted periodically, on a
prospective basis, "to reflect changes iT>-the
estimates of relative benefits, including a change
in the measurement standard if that becomes
necessary.
- 128 -
4. The costs to be shared should include all direct and
indirect costs determined in a manner -consistent with
U.S. tax accounting and expense allocation principles.
5. A party that contributes funds or incurs risks for
development of intangibles at an earlier stage must be
appropriately compensated by the other participants in
the form of a buy-in for the value of preexisting
intangibles (including basic research and the going
concern value of research capability).
a. Fully developed intangibles command a royalty and
should not be incorporated into a cost sharing
agreement, with the result that the buy-in may not
reflect compensation for fully developed
intangibles.
b. A secondary buy-in is required whenever a
participant withdraws from a cost sharing
arrangement or a new participant enters the
arrangement.
6. Expenses relating to marketing intangibles are
presently governed by the services provisions of the
section 482 regulations. There seems to be no need for
marketing expenses to be subject to a cost sharing
regime developed for manufacturing intangibles.
7. Cost sharing payments are not income to the recipient
but, instead, reduce costs that are otherwise
deductible for purposes of computing taxable income and
earnings and profits. Consequently, outbound cost
sharing payments are not subject to U.S. withholding
tax, and inbound payments are not foreign source
income.
8. Since a section 936(h) cost sharing payment is
compensation for intangibles previously developed and a
section 482 cost sharing payment is for the cost of
developing new intangibles, both amounts appropriately
must be paid initially if a possessions corporation
making the section 936(h) cost sharing election enters
into a section 482 cost sharing arrangement. Under the
statute, the section 936(h) payment may in no event be
reduced to reflect amounts paid under a section 482
cost sharing agreement.
9. . Taxpayers should be required to make Bfrrrmair^ lection
if they enter into a cost sharing arrangement, to file
- 129 -
a copy of the agreement with their return, and produce
records necessary to verify the computation and
appropriateness of the respective cost shares.
10. Cost sharing agreements in existence for more than five
-years prior to 1987 should be grandfathered if they
conform in certain respects with new rules to be
promulgated. Other agreements will not be bona fide ■ .
unless and until they substantially conform to the new
rules.
APPENDIX A
ANALYSIS OF QUESTIONNAIRE RESPONSES
IRS Access To Pricing Information
Significant section 482 Issues were identified by lEs over
70% of the time and by the domestic agent about 10% of the
time.
Significant section 482 issues were initially identified
using the following sources:
Source Percentage of Responses
Form 5471 50.36%
Form 5472 23.74%
Financial Data 13.67%
Prior Exam , 7.19%
Industry Experience 2.88%
Customs Data 2.16%
Time alloted to develop the 482 issue was determined by:
Percentage of Responses
Case Manager 51.32%
Domestic Group Mgr 7.78%
I.E. Manager 35.53%
Branch Chief 5.26%
About 66% of the lEs reported that the decision on time
allotment was made after receiving adequate opportunity to
analyze the section 482 issue.
Almost 90% percent of respondents stated the time
alloted to examine the section 482 Issue was flexible.
Factors affecting time allotment were:
Percentage of Responses
Potential yield 32.84%
Assurance of yield 4.48%
Both of the above 28.35%
Neither of the above 34.33%
Annual Reports to shareholders were used to identify or
develop section 482 issues in 34% of the cases.
- 2 -
The portions of the Annual Report specifically considered for
identification or development of section 482 issues were:
Percentage of Responses
Income Tax Notes 19%
Segment Information Note
for Product Line 31%
Segment Information for
Geographic Area 36%
Other 14%
65% of respondents thought that information on Forms 5471 and
5472 was helpful in planning exams.
In 29% of the reported cases, section 482 issues were
identified and not pursued. In 20% of the reported cases,
section 482 issues were identified and not changed.
The taxpayer had no readily available basis to support its
section 482 transaction in almost 75% of the cases.
In over 50% of the reported cases, taxpayers failed to make
timely and complete responses to questions asked in
developing section 482 issues.
More than 66% of the responses indicate that there was no
reasonable explanation for any delay in responding to
questions aimed at developing section 482 issues.
Reasons given for delays in responding to IDRs:
Tax department staffing.
Records located overseas.
Foreign parent refused to produce records.
' Extremely detailed requests for information from the
foreign subsidiaries.
* Lack of cooperation existed between the parent and
subsidiary.
Unreasonable delays in responding to requests for information
concerned:
'• Control of affiliates — 34.4% of responses.
' ' Existence of comparable transactions with third
parties -- 48.5% of responses.
- 3 -
Terms of comparable transactions with third parties
- 48.5% of responses.
The average length of delay to responses was 12.2 months.
The portion of the delay deemed as reasonable by the
responding lEs averaged 2.2 months.
Using a summons to obtain information was considered as
follows:
Percentage of Responses
Considered 41%
Discussed with taxpayer 34%
Employed 5%
IE descriptions of circumstances in which issuance of a
summons was considered:
Formal summons discussed - not used because case manager
felt that the action would close the door to future
cooperation in domestic audits.
It was felt that the issuance of a summons for records
would only delay the overall development and completion
of the case.
Summons considered due to delay in response to agent and
economist. Not issued as taxpayer eventually did
respond, although the responses were generally
inadequate.
Used as a threat to speed-up IDR response time.
Generally not useful. i
Taxpayer complained that our request was overly broad.
After discussion with Branch Chief, including the use of
section 982 and summons. Taxpayer offered an alternative
to books and records, under which most of the
information requested was eventually received.
Section 982 procedures arose to the following extent:
Percentage of Responses
Considered 26.6%
Discussed 17.6%
Employed 4.0%
- 4 -
IE descriptions of the circumstances in which section 982 was
considered:
* ' The section 982 procedures were mentioned in opening
conference.
** Taxpayer's practice was to furnish as little information
as possible with approximately a 90-day turn around
time. When subsequent IDRs needed to be issued, the
same practice was followed.
* ' Taxpayer is well aware of our open year policy and
planned closing dates. IE was of the opinion that
taxpayer feels if they use delaying tactics the case
will become "old" and will be closed out undeveloped.
Taxpayer's delaying tactics prevented the issuance of
follow up IDRs. Taxpayer refused to furnish its
parent's cost data for the products that were at issue.
° * Taxpayer was late in providing data after initial
adjustments were prepared. Taxpayer's attorney's tactic
was to continue indefinite discussion of the issue,
including appeals to the National Office.
** Taxpayer's responses to IDRs took from 6 months to a
year. The audit was stretched out to the point that the
planned audit closing date became a problem.
Section 482 issues were raised on the previous audit.
The prior examiner received virtually no information
from the taxpayer. Detailed information was submitted
by the taxpayer in the Appeals protest. This
information was used by the IE and the economist in
subsequent years.
** Taxpayer clearly not responsive to IDRs that could hurt
him. In three cycles, the key IDRs were not answered.
District allows taxpayers excessive amount of time to
respond to IDRs. A two year audit cycle takes five
years to complete.
According to responding lEs, the following adversely
affected the development of section 482 issues:
- 5 -
Number of
Responses
Yes
No
21
44
28
39
31
30
a) 3.0, 5 open years policies
b) Planned audit closing dates
c) Taxpayer tactics
Competent Authority considerations affected the resolutions
of 10% of the reported cases.
Only 3% of respondents claimed that competent authority
considerations affected their decision to pursue any section
482 issue.
Appeals settled 28% of the section 482 issues in the reported
cases.
69% of respondents disagreed with the terms of the Appeals
settlement.
Counsel was involved in 26% of cases settled by Appeals.
76% of respondents did not receive a copy of the Appeals
settlement.
The section 482 issues were resolved at the examination level
43.4% of the time in the reported cases.
The IE was appropriately consulted in 90% of the reported
cases resolved by Examination.
The section of the 482 regulations providing the basis for
Examination's resolution was:
Percentage of responses
Comparable uncontrolled price 32%
Resale price method 8%
Cost plus method 24%
Other 36%
The IE agreed with the resolution by Examination 85.7% of the
time.
- 6 -
B. Application of Pricing Methods
lEs stated that the taxpayer used comparables as follows
with regard to section 482 transactions:
Percentage of responses
Planning transactions
Defending transactions
Did not rely on comparables
9%
33%
58%
71% of lEs who responded stated that the comparables used
were not made available to them at or near the beginning of
the examination.
Description of comparable( s ) relied on by taxpayer in
planning or defending its section 482 transaction:
In performance of services, taxpayer tried to
establish comparables based on charges to third
parties.
The taxpayer presented pricing data with an unrelated
distributor of similar property in a different country.
Sales invoices to third parties.
Contracts between unrelated third parties.
Taxpayer claimed it was charging the same royalties
to all of its foreign subsidiaries.
Taxpayer secured quote from third party in small
quantity transaction.
Weighted average of Canadian CFC's third party sales.
Method required by Revenue Canada.
Sales to 50% owned subsidiaries.
Industry norms.
Only 19% of those responding accepted the taxpayer's
comparables.
Examples of explanations why taxpayer's comparables were
not accepted:
- 7 -
The taxpayer was looking only at the services and not
looking at the overall transaction, i.e. providing
services, the transfer of technology and other
intangibles.
The comparables did not reflect true arm's length
pricing because they ignored the fact that the
parent performed substantial marketing, distribution,-
and trademarking functions, or the circumstances were
otherwise different.
The taxpayer's method generated approximately 185%
of the combined profit to the low tax entity and a loss
to the U.S. parent.
The taxpayer's comparables included very small volumes.
The taxpayer relied on comparables based on "industry norms"
in 41% of the cases reported.
Description of industry average "comparables" submitted by
the taxpayer to support its assertions:
Robert Morris Associates -- Annual Statistics by SIC
Code of Gross Profit Margins for Wholesale Automotive
Equipment Dealers.
'* Taxpayer relied on published AFRA demurrage rates.
* * Taxpayer used the average resale mark-ups for the
industry.
Comparables were used as a basis for adjustment in about 75%
of the cases reported.
Representative sources for finding comparables relied upon
by lEs:
•* The IRS Economist used industry (construction)
comparables. The services that the offshore company
performed were that of a construction manager. The
economist determined that, based on comparables, the
offshore company should receive a comparable profit.
The remaining profit was allocated back to the taxpayer
for services and intangibles.
* * Economist used industry statistics from docketed cases
and SEC reports of unrelated taxpayers.
' ' Taxpayer was requested and did provide comparable
transactions of its manufacturer parent with its
unrelated distributors.
- 8 -
* * Information from third parties with respect to
comparable transactions (a similar product under similar
circumstances in a similar market).
License agreement with related and unrelated parties.
Analysis of industry, consulting with ISP, contacting
other lEs examining similar companies.
Third party agreements for similar services or
intangibles with same taxpayer in same circumstances.
Obtained Form lOK information from several U.S. entities
and used to establish the arm's length price on a cost
plus basis.
Third party sales of taxpayer and compiled statistics
from "Robert Morris & Associates - Annual Statement
Studies. "
The following are descriptions of significant problems
encountered by lEs in developing a comparable:
The information sought from third parties was old - 5
to 6 years. In one instance the third party relocated
and finding records was difficult. Records were not
organized when obtained.
Difficulty in acquiring information from third parties
and obtaining permission to use data from the third
party.
Adjusting for differences in geographic markets.
There are no comparables at this level of distribution.
All manufacturing/sales companies in this industry are
related.
The products manufactured and sold by the Puerto Rican
affiliates were the high volume, profitable
products. The functions performed by the subsidiaries
did not correspond to any third party situation.
Consequently, the comparables identified were useless.
Methods used in proposing tangible property adjustments by
percentage of response:
Comparable Uncontrolled Price 31%
Resale Price Method 18%
Cost Plus Method 37%
Other Method 14%
- 9 -
A majority of lEs who responded claim that the priority
of methods was useful in development or analysis of the
tangible price issue.
Market penetration was not considered as a factor when
determining section 482 adjustment in about 75% of the cases
reported.
The taxpayer's documentation considered the priority of
pricing methods in 50% of the cases reported where,
documentation existed.
Excerpts of descriptions of "other methods" used by the
taxpayer to justify its pricing policies.
** Taxpayer claimed intercompany price was arm's length
because it was negotiated between the lower tier sub
and its foreign parent.
* ■ Taxpayer contended all income attributable to
intangibles belonged to the Puerto Rican
affiliate.
' * Prior appellate settlements.
* * Taxpayer attempted to identify other charges made by
the parent to its subsidiaries that were equivalent to
the royalty adjustment that was proposed.
' ' Taxpayer explained its method as being required by
Revenue Canada.
*' "Old fashioned business know-how".
In over 75% of the cases reported, the taxpayer
relied on a profit split to determine its transfer price.
Descriptions of taxpayer's methods of computing profit
split:
*' Market penetration accounted for any difference in
price.
' ' Resale price.
* ' Taxpayer computes revenues of products made in Puerto
Rico then reduced them by: cost of sales P.R., an R&D
cost sharing amount based on section 936(h), selling
and administrative expenses based on a fractional
- 10 -
calculation and other income or expenses using section
936(h) - this gave CTI of which they considered the
P.R. entity to possess half.
Taxpayer used prior Appeals settlement profit split.
Taxpayer allowed its domestic subsidiaries a profit of
6% on the cost incurred by such subsidiaries »
Taxpayer used profit earned by the parent on other
transactions with related parties. Taxpayer's
contention is that the subsidiary's high profit is
irrelevant as long as the parent made an adequate
profit on the transaction.
Taxpayer claimed that the marketing company should
recover all of its marketing costs (11% of sales)
plus derive a profit (4% of sales).
- 11 -
C. Services
The lEs proposed an adjustment for services In 32.8%
of the reported cases.
In 43% of the reported cases, difficulty in applying the
services regulations was the primary reason for not making an
adjustment.
Difficulties reported by lEs in applying the service
regulations included:
Determining for whose benefit services were provided.
*• Undue burden on the IE to: (1) isolate costs, (2)
determine whether the service was an integral part of
the business, and, (3) develop comparables to determine
proper adjustment.
Determining what services were rendered, by whom, the
amount of time spent rendering the service, and the
cost of the service.
* * The service regulations do not allow a profit in the
allocation.
Examples of difficulties in deciding whether to propose an
adjustment for services rendered or intangibles transferred
included:
* * Taxpayer only wanted to charge for services at the same
rate they generally charged third parties. IE used a
functional analysis to show that know-how was also
transferred to related parties but not to third parties.
* * Taxpayer does purchasing for a subsidiary and picks up a
5% profit. IE had no idea if the profit mark-up was
appropriate.
** Taxpayer allocated a portion of cost based on time spent
by officers. Because of the 25 percent rule, the IE was
prevented from making an adjustment.
- 12 -
D. Intangibles
50% of the cases reported involved a significant transfer of
intangibles.
Adjustments were made under Treas. Reg. §1.482-2(d) in
about 50% of the reported cases.
Factors reported by lEs as affecting the decision to
proceed under services or sales of tangible property
regulations rather than under the intangibles section:
a) Inability to separately identify
the intangible 39.2%
b) Inability to document the transfer 17.4%
c) Inability to value the intangible 43.4%
IE recommend changes in the regulations that would have made
an adjustment for intangibles more feasible:
" * Spell out that T/P's reputation is an intangible.
* * Clarify that a CFC should not get a marketing
profit if they don't do marketing.
In reported cases involving the transfer of intangibles to a
related party, the taxpayer acknowledged the transfer at the
outset of the examination 48.6% of the time.
Documentation produced by taxpayers with respect to the
transfers of intangibles:
* * Unrelated professional appraisal
° ' Corporate minutes and legal documents
* ° Licensing agreements
a. With related entities
b. With unrelated entities
* ' Section 351 transfer documents
* ' Section 367 ruling
• Marketing intangibles were involved in 25% of the intangible
cases.
- 13 -
Data relied upon or method of intangible valuation:
Advertising and marketing expenses
Trade name and trademark defense costs
* * Distribution costs
Market dominance - 3rd party brokerage statements
- market studies - royalties textbooks - profit and loss
comparisons - patent infringement cases -
prevailing rates in the industry.
Compared rates charged by taxpayer to unrelated
parties.
* ' Used functional analysis to show that CFCs were
not active in crude oil trading. Only administrative
and communication services were performed. Economist
determined an arm's length service fee due the CFC for
services performed, then used the residual method to
value the income to be allocated to the domestic
subsidiary.
Taxpayers used a cost sharing agreement with a related party
in 17 1/2% of the cases reported.
Description of cost sharing agreements:
■ * Parent billed Puerto Rican subsidiary for their
share of R&D.
'* R&D costs shared based on percentage of sales.
Direct costs charged to entity deriving benefit.
'* Reimbursed for R&D, marketing, and administration.
■* Share in R&D and reimbursed marketing costs.
- 14 -
E. Use of Specialists and Counsel
The following specialists were Involved with reported cases;
Percentage of responses
Engineer 18%
Economist 59%
Appraiser 2%
IE descriptions of Issues considered by specialist and how
the specialist was brought Into the case:
Economist performed a functional analysis of
activities of CFCs and Identified comparables.
The economist was requested after the
taxpayer prepared a section 482 study to
refute the proposed adjustment. In order to
be successful in Appeals or court, an
economist was considered essential.
An economist was requested to assist In
developing the third party comparables found
by the IE and to assist in assessing
taxpayer's arguments.
An economist was involved in the prior year
and, accordingly, was requested for the
current cycle. An engineer was needed to
assess the electrical engineering function of
the related companies.
An economist was requested for a valuation of risk
capital.
An engineer was used to compare the CFC shop to
unrelated shops. An economist found comparable
mark-ups.
An economist was used on an Informal basis as
to procedure and appropriate percentage of
profit.
An economist was used on the royalty expense
Issue and to evaluate a trademark transfer;
engineer was used to evaluate a fee structure.
- 15 -
The economist was requested to review our
position with respect to imputation of royalty
and technical service income. Looking beyond
this, the economist suggested that a potential
pricing issue existed. The economist was
assigned late in the examination and was not
granted the time needed to develop the pricing
issues.
The economist added support in the development
of the transfer of intangibles issue. The
economist was brought into the case after we '
recognized and began developing the issue.
An economist was requested by IE - used to establish
arm's length pricing of foreign autos.
An appraiser was brought in by the IE and the Case
Manager to evaluate the sale of U.S. entity's
stock at book value and to establish control elements.
The economist performed a functional analysis on Puerto
Rican operations. It was difficult to attack taxpayer's
pricing as long as we accepted the function of the
Puerto Rican subsidiary as a full-fledged manufacturer.
IE received informal advice on a stewardship issue.
According to the lEs, specialists were brought in at
appropriate times in 91% of the reported cases.
Specialists raised additional issues in 9% of the reported
cases.
79% of respondents thought that specialists'
reports were particularly useful in proposing issues.
Brief descriptions of specialists' reports which were
helpful :
The economist report was very useful since it
discussed, in depth, the functional analysis and
comparables used in determining the arm's length
rates for intangibles and services.
Economist report supported the lE's conclusion that
market penetration was not prevalent in the years under
examination, which was the thrust of the taxpayer's
argument.
Economist report gave a basis for reasonable profit
factor in pricing computation.
- 16 -
The economist's report was useful in establishing the
service fee for CFC and the function of taxpayer's
worldwide trading activity.
The report made a good case for treating the subsidiary
as a contract manufacturer. Prior to that, taxpayer
was maintaining its position that the resale method
applied.
The economist developed a method of joining data secured
by means of a private survey with data from a public
source. The economist revealed to the agent a number of
other sources that are available for statistical
analysis and comparisons.
Specialist's reports were used:
Percentage of Responses
To support an adjustment 87.5%
Not used 10.0%
Responses indicate that specialists did not cause an undue
delay in 90% of the cases.
14% of respondents stated that restrictions were placed on
their use of a specialist.
The taxpayer employed a specialist in 27% of the reported
cases.
The taxpayer's use of a specialist was as follows:
Percentage of Responses
Planning section 482 25%
transaction
Involved in audit 80%
IRS Counsel was involved in 39% of the reported cases.
14% of respondents claimed that had counsel been involved,
their cases would have been better developed.
Counsel was involved at a timely stage of case development
in 76% of reported cases.
Persons who determined that counsel should become involved
were :
- 17 -
Percentage of Responses
Case Manager 22%
Domestic Group Manager 3%
IE Manager 38%
IE 32%
Industry Specialist 5%
The types of legal assistance rendered:
Percentage of Responses
Activity
District Counsel technical
assistance 61%
National Office technical
advice 11%
Summons review 20%
Section 982 proceedings
review 7%
The assistance rendered by counsel was considered useful in
development of section 482 issues in 68% of responses.
.APPENDIX B ;..
SECTION 4E2 QU£3TI0MCAIRZ--IJrrE?i.-ATI0Kkl EXAy.ZKZP.S
%
CASE NAME
Years
PLEJISE ATTACH A COPY OF YOUR EXAMIKATION REPORT
ON THIS CASE TO YOUR RESPONSE
TO THIS QUESTIONNAIRE.
Please check the appropriate columnCs). Check:
(A) if the listed section 482 issue was present in this case;
(B) if the taxpayer agreed to the proposed adjustment; and
(C) if the taxpayer did not agree to the proposed adjustment,
Please enter the dollar amount of the proposed adjustment in
column (D).
(A) (B) (C)
Dd
lit
Transfer pricing
Income allocation
(other than transfer pricing)
1223 [2]
Expense allocation
(not including cost sharing agreements).
[L9]
Cost sharing agreements
[1]
Intangibles [1^
Services • [id
Interest D7]
Rental expense [ 1]
Gain allocation [2]
Miscellaneous [5]
tl2]
[0]
[5]
[3]
ao]
[13
[13
[23
[2(3
[13
CL93
[03
tlQl
[83
[10]
[03
[i3
[2 3
s
5.9
(D)
billion
s
1.1
billion
$
105
million
S
s
4fi0
m:lMnri
s
34
million
s
175
ma.llior.
s
—
s
27
rj.llior.
s
5$
rrj.llion
(Please briefly identify. Do not further iden
in this questionnaire any routine adjustments
and administrative or overhead expenses of rel
ly or discuss
to the general
ated parties . )
[ ] Please check here If this case involved section 936
[ 3 Please check here if you have answered q-aestion 100 on this
qfuestionnaire.
SrCTION 4S2 QUESII0KK;^1RE — IK7£iUN2kTI0K?.L EXAKINZRS I
1, Who initially identified the significant 482 issues in this
case? (Please check the appropriate box or boxes and
briefly identify the issues raised by each- )
- Domestic agent [ 9] _:
Case manager [0]
Domestic group manager [0] \
Yourself 57] I
I.E. group manager [1]
Economist [3]
0-cher 10]
If other, please identify.
2- Please list each of the significant 482 issues in this case
in the spaces provided below. (Use an additional sheet to
identify other significant 482 issues, if any.) Please also
indicate how each of these issues was initially identified
(whether by you or by sor.eone else) by filling in the number
corresponding to the method used to identify the issue in
the space below.
(1) Form 5471
(2) Form 5472
(3) Financial data
( 4 ) Prior exam
(5) Experience with the industry
( 6 ) • Customs data
(7) 0-her (please briefly explain in the appropriate
space )
(8) Do not knovJ hew issue was identified by another
person
Issue How identified?
A.
B.
C.
D.
E.
F,
(1)
70
(2)
33
(3)
19
•
(4)
10
(5)
4
(6)
3
(7)
SECTION 482 QUESTIONNAIRE — INTE?IKAT ZONAL EXAKINERS 2
3. Who principally determined the amount of time alloted to
developing' the 482 issues in this case?
A. Case manager [3^
B. Domestic group manager [^
C. I.E. manager [2'1\
D. Branch chief [ ^
E. Exam chief [ (3
4.- Was the decision on time allotment made after you had an
adequate opportunity to analyze the 482 Issues?
Yes [41] No [23
5. Was the time allotment flexible?
Yes [51] No [6]
6. Was the amount of tine alloted to the development of the 4E2
issues in this case affected either by the potential yield
or the likelihood that there would be a yield? (Check one.)
A. Potential yield affected allotment [23
B. Assurance of yield affected allotment [ 3]
C. Both affected the allotment . [19]
D. Neither affected the allotment [23]
7. Did you use one or more annual reports to shareholders to
identify' or develop a 482 issue?
Yes [24] Please continue.
No [46] Skip to C'J»»stion 10.
8. Which of the following portions of the annual report, if
any, were specifically considered? (Check if considered. )
A. The income tax note to the financial statement [8]
B. The segmental information note for
product line data * [-5
C. The segmental information note for
geographic area data . [l^
D. Other t ^
(please identify)^
3 identified .
SECTION 482 QUESTI01W2.IK.E — IKTERKRTIOKAL EXAKIKERS
9. Who initiated the use of annual reports in your
consideration of the 482 issues in this case?
- A. Yourself D2]
B. Domestic group manager [0]
C. Case manager [0]
D. I.E. group manager [0]
E. Domestic agent [2]
F. Other [3]
(please identify)
10. Was the information required to be reported on Forms 5471 or
5472 (or predecessor forms) helpful or inadequate in
planning the exam?
Generally helpful Be]
Generally inadequate [19]
11. Please briefly describe any specific information required to
be reported on these forms that you found helpful in
planning your examination in this case.
46
12. Please briefly describe any specific respects in which the
information now required to be reported on Forms 5471 and
5472 was (or would have been) inadequate in this case. What
specific additional information reporting requirements would
have been useful in the planning and conduct of your
examination in this case? (For example, would your case
development have been improved if taxpayers were
affirmatively required to disclose the transfer pricing
method relied upon by the taxpayer? )
36
SECTION CS2 QI;ESTI0NN?.IP.£ -- IKTZPJtATIOKAL EXAKINZRS
13. Were there_any identified 4B2 issues that were not pursued
or that were no-changed?
A. Not pursued? Yes D.9] No [47]
B. No-changed? Yes D-O] No [40]
If you answered yes to either question, please briefly
identify the issue(s) and explain.
23
14. Did the taxpayer have readily available the basis and
support for its section 482 transactions?
I
Yes [ig No [5]J
15. Did the taxpayer generally make timely and complete
responses to the questions in your IDRs that were asked to
develop the 482 issues in this case?
Yes pi] Please skip to question 20.
No • [40] Continue.
16. Were there reasonable explanations for any delays by the
taxpayer in responding to the questions you asked in IDRs
that were aimed at developing the 482 issues in this case?
Yes [13] Please continue.
No [27] Skip to question 18.
17. . Please briefly describe any reasonable bases' for the delays
16 " •
SICTION 4E2 QUESTIONNAIRE — INTERNATIONAL EXAMINERS 6
18. Please indicate whether the taxpayer unreasonably delayed
responding to any questions in your IDRs that dealt with the
following:
Yes No
A. Control of affiliates
B. The existence of its comparable
transactions with third parties
C. The terms of its comparable
transactions with third parties
Cli]
[2]]
119]
pq
EL6]
LIT]
19. In the spaces below, please estimate the length of any delay (
and the portion of the delay, if any, that was reasonable.
Total time delayed
Reasonable portion of delay
12.2 mos
2.2 mos
20. Did IRS management become involved in attempting to secure
information from the taxpayer? If so, indicate each
management level involved and whether the information sough"!
was obtained as a result of that involvement.
Was the recuested
information
obtained?
■
Level
Yes
No
A.
B.
C.
D.
E.
No involvement
Group Chief
Branch Chief
Exam Chief
District Director
Da
[Id
[4]
[3]
[22]
CLI]
[2]
[1]
C19]
[9]
CIO]
Cio]
21. Was the use of summonses considered, discussed with the
taxpayer, and/or employed?
Yes
No
Considered?
P8]
[41]
Discussed?
Pl]
[40
Employed?
[3]
[54]
If you answered yes to any of the above, please briefly
describe the circumstances and the results obtained.
24
(space continues)
SECTION 482 QUESTIOKNAIRE — INTERl-iATlONAL EXAKINZRS
22. Was the use of section 982 considered, discussed with the
taxpayer, and/or employed?
Yes
No
Considered?
DT]
&7]
Discussed?
t S]
tl2]
Employed?
[ 21
K9]
If you answered yes to any of the above, please briefly
describe the circumstances and the results obtained.
13
23. Did you work with an economist, engineer, appraiser or othe:
specialist on the case?
Yes
No
A.
Engineer?
ao]
[461
B.
Economist?
[40]
[28]
C.
Appraiser?
[1]
[49]
D.
Other?
[9]
[40]
(If other, please
briefly describe.)
If you have answered yes to any of the above, please
continue.
If you answered no to all of the above, please skip to
question 34 .
.•'
24. Please briefly describe the issue(s) considered by any
specialist(s) and how the specialist( s ) was (were) brought
into the case.
43
(space ccr.t-r.jes )
SXCTION 432 QUESTIONKAIRE — INTERNATIONAL EXAKINERS 8
25. Was (were) the specialist(s) involved in the case at an
appropriate time?
[40] Yes, all specialists were brought into the case at
appropriate times.
[ 4] No, not all specialists were brought into the case
at appropriate times.
If no, please briefly explain.
26. Did the specialist ( s) raise new 482 issues?
Yes [ fl Please continue.
No [4(3 Skip to question 28.
27. Please briefly identify the 422 issues initially raised by
the soecialist( s) in the case,
9
28. Were any of the specialists' reports useful to you?
Yes [33 Please continue. *■
No - [ SO Skip to question 30.
29. Please briefly identify which report(s) was (wer«) useful,
and why.
_24
(space continues)
SECTION 482 QUESTIONNAIRE -- INTERNATIOK?.L EXAMINERS
30. Please briefly indicate which repDrt(s) was (were) not
useful, and why.
12
31. Kow were specialists' reports used in connection with your
proposed adjustment? (If more than one specialists' report
was prepared in this case, please fill in the appropriate
nur.ber of reports in t.he spaces provided.)
A. Report recommended against the adjustment [ 1]
B. Used to support adjustment D5]
C. Not used to support adjustment '' [4]
32. Did the involvement of any specialist unduly delay the case?
Yes" [ 4] No pO]
33. Did ar.yone place a restriction on your use of a specialist?
Yes [6] No pq
If yes, who? (Please identify. )^
34. Did the taxpayer employ a specialist?
Yes [l3 Please continue.
No [491 akip to question 36.
35. Was the taxpayer's specialist utilized in planning the
transaction, in refuting a proposed adjustment, or bcfr
SrCTION 482 QUESTIOlxKa-IRE — IKTERKr.TIOKAL EXAMINERS 10
Yes No
t
Involved in planning? [4] [13
- Involved in audit? tl6] [43 '
36. Did Counsel become involved in the case?
Yes [27] Please skip to question 38.
No [42] Continue.
37. Would the case have been better developed if Counsel had
become involved?
Better developed [ 6]
No difference p7]
Please skip to question 43.
38. Was Counsel involved at a timely stage?
Yes [22] Please skip to question 40.
No [7] Continue.
39. Would the case have been better developed if Counsel had
become involved at an earlier time?
Better developed [ 6] No difference [ 4]
40. V.^o determined that Counsel should become involved?
A. Case manager . [ d
B. Domestic group manager [ i]
C. I.E. manager [14]
D. Exam Chief [ q)
E. Yourself [12]
F. .Industry Specialist [23
41. Please check the appropriate box- to indicate the type of
assistance rendered by Counsel in this case.
A. District Counsel technical assistance
B. National Office technical advice
C. Summons review
D. Section 982 proceeding review
Oral
Written
1)183
[03
[43
[13
[9]
[5]
[5]
[2]
SrCTION 4S2 QUESTIONNAIRE — INTERNATIONAL EXAMINERS il
42. Was the assistance rendered by Counsel useful in your
developitient of the 482 issues in this case?
Yes [ig No [9]
43- Did any of the following adversely affect your development
of 482 issues in this case?
Yes No
A. 3.0, 5 open years policies
B. Planned audit closing dates
C. Taxpayer tactics
D. Other
If you checked yes for C. or D., please briefly explain,
[2]]
[44]
[231
P9]
[31]
PO]
[ 71
[27]
44. Were any of the 482 issues resolved in Examination?
Yes [3CJ Please continue.
No [3^. Skip to question 50.
45. Did Examination's resolution involve only the 482 issues in
the case. alone or was it part of a broader resolution?
482 issues resolution only [23]
Part of over-ali resolution [ 7]
45. Were you appropriately consulted regarding the resolution of
the 482 issue(s) in the case that were resolved in
Examination?
Yes' [27] No [3]
47. Which provisions of the 482 regnjlations provided the basis
for Examination's resolution of 482 transfer pricing issues
In this case?
A. Comparable uncontrolled price [83
B. Resale price method [2]
(question continues)
SECTION 482 QUZSTIONKAIRE — I NT ERK AT ZONAL EXAMINERS 12
C. Cost plus [6]
D. Any "other" reasonable method [9]
48; Did you agree with the resolution?
Yes [241 No [ 4]
If no, please briefly explain.
49. Did Competent Authority considerations affect Examination's
resolution of any section 482 issue in this case?
Yes [3] No [283
If yes, please briefly describe the transaction that gave
rise to this concern.
50. Did Competent Authority considerations effect your decision
to pursue or not pursue any section 4E2 issue in this case?
Yes [ 2] No [67]
If yes, please briefly explain.
51. Did Appeals settle any section 4B2 issue in this case?
Yes [17] Please continue.
No [44] Skip to question 54.
SECTION 4B2 QU£STIONK?-IR£ -- IKTIR-KRTIONAL EXAMINERS 13
52. Did you agree with the terms of Appeals' settlement of the
482 issuc('s) in this case?
Yes [5] NO til]
If no, please briefly explain. .
DD.
53. Wa's Counsel involved in the Appeals settlement?
Yes [ a No [141
54. Did you receive a copy of Appeals' final report on this
case?
Yes [9] No P9]
•.-r^^ "
in this case, were there difficulties establishing 'control
for purposes of section 482?
Yes [5] No [643
other than direct or
of a
56. Was control established by means other man a
indirect ownership of a majority of the stock
controlled corporation?
Yes [ H No ^1]
If yes, please briefly explain how control was established,
57. Did the taxpayer rely on comparables either in plar.r.ing or
defending its 482 transactions?
r 71 Relied on comparables in planning transactions
[42] Did not rely on cor^a-a-^es ^n ei ^nc k^
SXCTION 452 QUESTIONNAIRE — IKTERK?.TIOK?-L EXAMINERS 14
defending transactions. Please skip to question 62.
58. Were those comparables made available to you at or near the
beginning of the examination?
Yes [9] No [223
59. Please briefly describe the comparable( s ) relied upon by the
taxpayer in planning or defending its 4B2 transactions.
27
60. Did you accept the taxpayer's comparables?
Yes [ 5] No [22]
If no, please briefly explain why.
61. Did the taxpayer rely upon co-parables based on "industry
■ norms" in planning or defending its transfer pricing?
Yes [113 No [iq
If yes, please briefly describe the data provided by the
taxpayer to support its assertions.
SECTION 482 QUESTIONNAIRE — INTERNATIONAL EXAMINERS 15
62. Did you seek to use a comparable as a basis for making any
482 adjustments in this case?
Yes [43 Please continue.
No [25] If either you or the taxpayer sought to rely
• or relied on comparables, skip to question
67. Otherwise, skip to question 68.
63. Did you actually use a comparable as the basis for making
the 482 adjustments in the case?
Yes [34] No [13
64. How did you identify the comparable you used or sought to
use?
40
65. Were you able to properly develop information regarding the
comparable you used or sought to use?'
Yes (32] No D.1]
66. Please briefly describe any significant problems you
encountered in attempting to develop the comparable you used
or sought to use.
23
67. wy.at kind of adjustments, if any, were needed for both the
taxpayer and Ser-v-ice comparables to achieve arm's length?
(Please check all that apply. )
(question continues)
SECTION 482 OUESTIONKAIRE — IKTERNATIOKM. EXAMINERS 16
r,.,,o^mpnt coniDarable Taxpayer comparable
[9]
[12]
warranties and rebates [ 3
level of market t 73
[^8] geographic market [ 4]
[ 9] volume of transactions [ 8]
[ 6] length of agreement [ 4]
tl3 product differences [ 5]
[9] terms of sale [5]
[4] currency translation [ 1]
[13 other [6]
If other, please explain briefly. . —
12
68 In your opinion, did this case involve any significant
transfer or permissive use of any of the following: a_
patent, invention, formula, process, trade secret, design,
brand name, pattern, know-how, marketing expertise, or show-
how?
Yes [34] Please continue.
No [3J Skip to question 79,
69. Please briefly describe the patent, etc,
35
70. Did you specifically make an adjustment in this case for
intangibles under Treas Reg. 1.4B2-2(d)?
Yes [193 Please skip to qu'estion 73.
No " [2C0 Continue.
71. I
(
n making an adjustment f or ( 1) related party "^^"^'.^J^
v2) the transfer pricing of tangible property, did you .a.e
the transfer or use of intangibles into account^ „,,i,,es)
SECTION 4B2 QUESTIOKNXIRE — IKTERKATIONAL EXAMINERS 17
Y*s [ID Pleastt continue.
No [i3 Skip to question 73.
72. What factors dictated the decision to proceed iinder the
services or sales of tangible property regulations rather
than make an adjustment under the intangibles regulations?
A. Inability to separately identify the transferred
intangibles [ 9]
B. Inability to document the transfer or use [4]
C. Inability to value the intangibles [10]
D. Other [ i]
If other, please explain. ^
73. Which of the following factors were most important to you
and to the taxpayer in deterrr.ining the arm's length pricing
for the most significant transferred intangible in this
case? Please select up to five factors that were most
important to you and to the taxpayer 'and number them in
decreasing order of im.portance ( i.e. . five is most
important, one is least) in the appropriate spaces.
GoverTynent Taxcaver
ResTXjnses Weiaftt Resp onses Viteight
A. Prevailing rates in the same 14 3j6 6 4.7
industry for similar property
B. Offers of competing transferors 4. 4J) __4 3.0
C. Bids of competing transferees 3 1.7
D. Limitations on geographic
area covered 4 2JD _4 2.3
E. Nonexclusivity of grant 3 2."0 ^ ^-^
F. Uniqueness of the transferred
property 17 U . _B 2. 7
C. Likelihood of continuing
uniqueness .. 10 1^? 6 2.3
H. Patent or other legal protections 9 1^4 __7 1.1
I. Services rendered in connection
with the transfer of property 14 3^1 __§ 3.5
J. Prospective profits to be realized
by the transferee from the ^ .
property 19 h} J^ ^'^
K. Costs to be saved by the transferee
as the result of the transfer
of the property 12 _ 2.4 10 3.2
(question continues)
Determining Arm's Length Pricing of Transferred Intangibles
4 5
(5 is Most Icportant)
Factors considered Most Important by Taxpayers in Determining
•Arm's Length Pricing of Transferred Intangibles
The key to the factors on the previous pages are:
A. Prevailing rates in the sane industry for similar property
B. Offers of competing transferors
C. Bids of competing transferees
D. Limitations on geographic area covered
E. Nonexclusivity of grant
F. Uniqueness of the transferred property
G. Likelihood of continuing uniqueness
H. Patent or other legal protections
I. Services rendered in connection with the transfer of property
J. Prospective profits to be realized by the transferee from
the property
K. Costs to be saved by the transferee as a result of the
transfer of the property
L. Capital investment and start-up expenses of the transferee
M. Availability of substitutes for the transferred property
N. Prices paid by third parties where the property is resold or
sublicensed to them
0. Transferor's costs of development
P. Other facts or circumstances
SECTION ^E2 QUESTIOKKAIRE — INTERNATIONAL EXAMINERS IB
L. Capital investment and start-up
expenses of the transferee __8 2.1
M. Availability of substitutes for the
transferred property
N. . Prices paid by third parties where
the property is resold or
sublicensed to them
0. Transferor's costs of development
P. Other facts or circumstances
(please explain)
5
3.0
2
4
5
12
2.4
2.6
3
8
3.3
2.4
4
2.n
4
3.0
74. Did the taxpayer acknowledge at the outset the existence of
a transfer of inta.ngibles to a related party in this case?
Yes [15] Please continue.
No [11] Skip to question 76.
75. VThat documentation for the intangible transfer did the
taxpayer produce? Please briefly describe.
14
76. What changes, if any,- in the intangibles regulations would
have made an adjustment
this case?
12.
77. If there were marketing intangibles involved in the case,
did you attempt to value such marketing intangibles separate
and apart from the manufacturing or other intangibles
involved in the case?
(question continues)
SECTION 4B2 QUESTIONNRIRS — INTERKATIOKAL EXAMINERS 19
Yes [ ?] Please continue.
No P7] Skip to question 79.
78. Please briefly describe the method utilized to value the
marketing intangibles in this case and the type of data you
relied upon.
14
. 79. Did the 4B2 issues in this case involve the pricing of
tangible property?
Yes [40] Please continue.
No [2^ Skip to question 82. ''
BO. Which method did you use in proposing' your adjustment?
A, Comparable uncontrolled price?
Yes D-5] Please continue.
No p6] Skip to part G. of this question.
Please check the appropriate box if you relied on:
(1) transactions between the same taxpayer (or a
related taxpayer) and third parties; or
(2) transactions between two parties both of which
were not related to your taxpayer.
[ 4] Relied only on related party transactions.
Please skip to part G. of this question.
[12Q Relied on- one or more unrelated party
transactions. Continue.
B. Please briefly describe the unrelated party
transaction(s) you relied upon to develop your
comparable ( s ) .'
(space for answer on next page)
SrmON 4 32 QUESTIOKNAIRE — IKTEHNATIOKAL EXAMIKERS 20
C._ Were you able to disclose to the taxpayer the terms of
the corr.parables( s ) you documented through unrelated
party transactions?
No. [ 51 Please continue.
Yes. [ 6] Skip to part G. of this question.
D. Please briefly describe the reasons (promises of
confidentiality, etc.) that you were unable to discuss
the terms of the comparable with the taxpayer.
E. If it became necessary, would you have been able to
disclose the terms of the com.parable( s ) you documented
through unrelated party transactions as evidence in
cou
"t ">
No. [2] Please continue.
Yes. [5] Skip to part G. of this cjuestion.
T. Please briefly describe any impediments to your
introduction of the terms of the comparableC s ) in court
that were different than those described in part D. of
this question. (If no difference, please write
"Same.")
(space continues)
SECTION 482 QUESTIONNAIRE — IKTExUx-?.TIONXL EXAKINE71S 21
G. Resale price methoci?
H. Cost-plus method?
I. "Other" method?
If other, please describe briefly the "other method'
used by you.
Yes
[9]
No
[213
Yes
as]
No
U3]
Yes
[7]
No
a-T]
81. Was the priority of methods required under Treas. Reg. sec.
1.482-2(e) useful or detrimental in your development or
analysis of the tangible transfer price issue?
Useful [19] Detrimental [17]
If detrimental, please briefly explain. ^
82. In considering any proposed adjustments under section 482,
did you consider whether the taxpayer's interest in
"penetrating" a new market needed to be taken into account?
Yes [l-a No tl7]
83. In its responses to your proposed adjustments, did the
taxpayer argue that your proposed pricing adjustments needed
to be modified to take into account its market penetration
goals?
(question continues)
SECTION 482 QUESTIOKNAIRE — IKTERKATIOKrLL EXAKIKEP.S 22
Yes [5] Please continue.
No K2] Skip to question 87.
84. For how many years had the taxpayer sold in that market?
9 responses 17.88 years (average)
85. Did you accept the taxpayer's contentions?
Yes [ 2] Skip to question 87.
No [ 6] Please continue.
86. If you rejected all or part the taxpayer's contentions vith
respect to market penetration, please briefly explain.
87. Did the taxpayer provide you with contemporaneous
documentation regarding the methods it used to set its
transfer prices?
Yes" 0.6] Please continue.
No t48] Skip to question 89.
BS. Did the taxpayer's documentation expressly consider the
priority of pricing methods set out in Trees. Reg. sec.
1.482-2(6)?
Yes ao] No ao]
89. Please describe briefly any "other method" used by the
taxpayer to justify its pricing policies.
SiCTION 4.S2 QutSTIONNXIPZ — IKTr?JsF.TIOKRL EXAMINERS 23
90. Did the taxpayer contend in Examination that its "other
reasonable method" of transfer pricing resulted in an
appropriate profit split, or did it rely on a profit split
to determine its transfer prices?
Yes [14] yiease continue.
No [49] Skip to question 92.
91. Please briefly describe the taxpayer's means of computing
the profit split it utilized or defended as appropriate.
11
92. Did this taxpayer utilize a cost sharing agreement with a
related party?
Yes [12 Jlease continue.
No [53 Skip to question 95.
93. Please briefly describe the cost sharing agreement. _
11 ■
54. Please briefly describe any adjustments you proposed to ir.cke
to the expense allocations required by this agreement.
95. In this case, did you have difficulty deciding whether to
propose making a 482 adjustment based on --
SiCTION 4 82 QUESTIONNAIRE — INTERNATIONAL EXAMINERS 24
(1)- services performed by one related party on behalf
of another;
or --
(2) transfers of intangibles between the related
parties?
(Example: Did you have to decide between proposing an
adjustment based on (1) a parent corporation's "training"
its new subsidiary's employees, or (2) the parent's transfer
of "know-how" to the new subsidiary?)
Yes [190 Please continue.
No [430 Skip to question 97.
95. Please briefly describe the issue.
18
97. In this case, did you consider proposing an adjustment based
on the provision of services by one related party to
another?
Yes C2] Please continue.
No &5] Skip to question 100. •
98. If your proposed adjustments did not include an adjustment
with respect to related party services, was your decision
based on difficulties in applying the services regulations
under section 482?
Yes [13] Please continue.
No [17] Skip to question 100.
99. Please briefly describe any specific difficulties you had
applying the services regulations.
8
SECTION 482 QUESTIONNAIRE — INTERNATIONAL EXAMINERS 25
100. If we have overlooked asking about any significant 482
issues that you believe could be better addressed in
regulations, please take the time to identify the issue, the
regulation, and any thoughts you have about how that
regulation might better address the issue. Please do not
confine yourself to the issues raised in this case. Please
attach additional sheets if necessary.
APPENDIX C
TRANSFER PRICING LAW AND PRACTICES OF SELECTED
U.S. TREATY PARTNERS
CANADA
The statutory basis for transfer pricing allocations is
section 69(2) of the Income Tax Act^ that provides as follows;
Where a taxpayer has paid or agreed to pay to a non-
resident person with whom he was not dealing at arm's
length as to price, rental, royalty or other payment
for or for the use or reproduction of any property or
as consideration for the carriage of goods or passen-
gers, or other services, an amount greater than the
amount (in this subsection referred to as the "reason-
able amount" ) which would have been reasonable in the
circumstances if the non-resident and the taxpayer had
been dealing at arm's length, the reasonable amount
shall, for the purpose of computing the taxpayer's in-
come under this Part, be deemed to have been the amount
that was paid or payable therefor.
Section 69(3) of the Income Tax Act provides as follows:
Where a non-resident person has neither paid nor agreed
to pay to a taxpayer with whom he was not dealing at
arm's length as to price, rental, royalty or other pay-
ment for or for the use or reproduction of any pro-
perty, or as consideration for the carriage of goods or
passengers or for other services, the amount that would
have been reasonable in the circumstances if the non-
resident person and taxpayer had been dealing at arm's
length, that amount shall, for the purposes of comput-
ing the taxpayer's income under this Part, be deemed to
have been received or receivable by the taxpayer
therefor.
Sections 69(2) and (3) apply to all taxpayers including
individuals, unincorporated businesses, trusts, and corporations.
However, section 69(2) applies only when the Canadian taxpayer
has paid more than a reasonable amount and does not apply when
the Canadian taxpayer has paid less than a reasonable amount.
Similarly, section 69(3) applies only when the Canadian taxpayer
has received less than a reasonable amount and does not apply
when the Canadian taxpayer has received more than a reasonable
amount .
i Income Tax Act, S.C. 1970-71-72.
- 2 -
Interpretation of this statute by the Canadian government
has been provided in an Information Circular issued by the
Department of National Revenue in 1987.^ In this Circular,
Revenue Canada interprets the phrase "reasonable in the
circumstances" to mean the price that would have prevailed if the
parties to the transaction had been dealing at arm's length o In
applying this arm's length standard. Revenue Canada has endorsed
the methods enumerated in the 1979 OECD report on Transfer
Pricing and Multinational Enterprises. Although the methods are
not prioritized as to the order that they must be used. Revenue
Canada has expressed a preference for the comparable uncontrolled
price method and the following sequence of tests:
1. Sales by the taxpayer to unrelated parties;
2. Comparable transactions between unrelated third
parties;
3. Resale price method;
4. Cost plus method; and
5. Any other method in support of the other methods or
where the other methods are inappropriate.^
These methods apply to the sale of goods as well as to the
acquisition or disposition of intangible property. With respect
to royalty rates on the disposition of intangibles. Revenue
Canada's Information Circular states that, in determining an
arm's length rate, the focus will be on:
a) prevailing rates in the industry;
b) terms of the license, including geographic
limitations and exclusivity of rights;
c) singularity of the invention and the period for
which it is likely to remain unique;
d) technical assistance, trade-marks, and "know-how"
provided along with access to the patent;
e) profits anticipated by the licensee; and,
f) benefits to the licensor arising from sharing
information on the experience of the licensee.*
In addition, when only use of the intangible is transferred, it
must be determined whether the transferee's payment is "in fact
2 Department of National Revenue Information Circular No.
87-2, International Transfer Pricing and Other International
Transactions (Feb. 27, 1987).
^ Id. at paras. 13-19.
* Id. at para. 46.
- 3 -
for the use of the intangible for the year — as opposed to a
payment for its outright acquisition or other capital outlay. "^
FRANCE
The statutory basis for transfer pricing allocations is
Article 57 of the French General Tax Code which is as follows:
In assessing income tax due by enterprises which are
subordinated to or controlled by enterprises
established outside France, the income to which is
indirectly transferred to the latter, either by
increasing or decreasing purchase or sale prices, or by
any other means, shall be restored to the trading
results shown in the account. The same procedure is
followed with respect to undertakings which are
controlled by an enterprise or a group of enterprises
also controlling enterprises located outside France.
Should specific data not be available for making the
adjustments provided for the preceding paragraph, the
taxable profits are determined by comparison with those of
similar undertakings run normally.*
The tax administration has endorsed the 1979 OECD Report on
Transfer Pricing and Multilateral Enterprises, although the OECD
guidelines are not binding on the French authorities.' In
enforcing Article 57, the authorities generally compare profit
margins of similar entities to identify any abnormalities."
A similar approach is apparently taken with respect to the
payment of royalties by a French taxpayer in that a deduction
will be allowed for the payment only to the extent that the net
income of the payee or subsidiary is at least equal to that
realized by a French enterprise engaged in a similar activity.-
^ Id. at para. 42.
' Code General des Impots, art. 57.
' See Instruction Administrative (May 4, 1973), published
in Bulletin Official de la Direction Generale des Impots 4A-2-73
" BNA, No. 364-9253, France: Transfer Pricing Within
Multinational Enterprises and Article 56 of the French General
Tax Code 11 (1980).
- 4 -
Furthermore, under the French exchange control law, all royalty
agreements with and payments to nonresidents must be reported,
prior to payment, to the National Institute of Industrial
Property.'
The experience of the Office of Assistant Commissioner
(International) is that French companies filing consolidated
returns that include foreign subsidiaries must agree to allow
French tax authorities on-site inspection of the subsidiaries'
books and records; that, as indicated above, profit experience is
a very important factor in examinations; and that no guidelines
have been developed for evaluation of royalty cases involving
transfer of intangibles. When intangibles are transferred to a
tax haven, payments received on account of the transfer are
deemed to be unreasonable, and the burden is on the taxpayer to
establish that the payments are reasonable.
Although cost sharing arrangements are permitted, ^° the
French authorities do not have specific rules applicable to such
arrangements .
GERMANY
The statutory basis for intercompany pricing adjustments
includes Article 8(3) of the Corporation Tax Law, which states
that hidden distributions of income do not reduce taxable
income.^ ^ Section 31 of the Corporation Tax Regulations
interprets "hidden distributions" to include a benefit granted by
a company to a related person, outside the normal statutory
profit distributions, which an orderly and conscientious manager
would not have granted to an unrelated party under comparable
circumstances . ^ ^
Similarly, Article 1(1) of the Foreign Tax Affairs Law
states that where the income of a taxpayer resulting from his
business relationship with a related person is reduced because
the taxpayer, within his business relationship extending to a
foreign country, has agreed on terms and conditions which
deviate from those unrelated third parties would have agreed upon
under the same or similar circumstances, then his income shall,
notwithstanding other provisions, be determined as if the income
had been earned under terms and conditions agreed upon between
' Id. at 11.
1° Id. at 11.
^^ Koerperschaftsteuergesetz art. 8(3).
^^ Koerperschaftsteuerrichtlinien §31.
- 5 -
unrelated third parties. ^^ Article 1(1) applies to all related
or affiliated taxpayers, including individuals, partnerships, and
corporations .
Paragraph 2.1.1 of the Transfer Pricing Guidelines of 1983^*
(hereinafter referred to as Guidelines) requires that business
dealings between related parties be evaluated on the principle of
arm's length dealings between independent parties acting in a
situation of free competition.
Paragraphs 2.2.2 through 2.2.4 of the Guidelines list the
following as the standard methods for evaluating transfer prices:
comparable uncontrolled price method, resale price method, and
cost plus method. In contrast to section 1 .482-2(e ) ( 1 ) ( ii ) ,
which requires that these methods be used in the order prescribed
if the circumstances of the case permit, paragraph 2.4.1 of the
Guidelines states that, "[t]here is no single correct sequence of
standard methods for the examination of transfer prices which
applies to all groups of cases." Also, paragraph 2.4.2 of the
Guidelines, similar to the "fourth method" provision of section
1.482-2(e )(1 )(iii ) , allows use of a combination of the three
standard methods or of other methods.
In cases involving transfers of intangibles to offshore
manufacturing affiliates, paragraph 5.1.1 of the Guidelines
recognizes that a determination must be made whether the
transferor has received an adequate consideration for the
transfer of the intangible. Paragraph 5.2.2 of the Guidelines
states that an arm's length price for transfer of an intangible
is to be determined under "an appropriate method." Paragraph
5.2.3 of the Guidelines indicates that the preferable method is
the comparable uncontrolled price method but, if the facts of a
case will not support application of this method:
then the starting point for the examination is the
consideration that a sound business manager of the
licensee enterprise would only pay a royalty up to an
amount which leaves the enterprise with an acceptable
commercial profit from the licensed product. [Emphasis
added. ]
According to paragraph 5.2.4 of the Guidelines, the cost plus
method may be used "in exceptional cases." One such exceptional
case is described in paragraph 3.1.3 (Example 3) of the Transfer
Pricing Guidelines of 1983, as follows:
^^ Koerperschaftsteuergesetz art. 1(1).
^* See Intl. Bureau of Fiscal Documentation, The Tax
Treatment of Transfer Pricing (1987) (English translation),
- 6 -
An enterprise transfers particular manufacturing
functions to a foreign subsidiary corporation.
Production and marketing by the foreign corporation are
closely tied in with the business of the domestic
enterprise.
The articles produced are purchased by the parent
corporation under a long-term arrangement. The
subsidiary corporation with its limited range of
production could not in the long run survive as an
independent corporation. Between unrelated parties the
production would have been carried out on a sub-
contract basis.... The transfer price can accordingly
be determined using the cost plus method.
This approach is essentially the same as that of the IRS in the
Lilly case, discussed supra . Chapters 4 and 5.
One commentator, Mr. Friedhelm Jacob, Counselor for Tax
Affairs at the West German Embassy in Washington, D.C., has noted
that, in contrast to the 1986 Tax Reform Act amendments to
section 482, which require adjustments over time for substantial
changes in circumstances, the German approach has been that the
determination of fair market consideration for an intangible is
made at the time of the transfer. ^^
Paragraph 2.4.3 of the Guidelines recognizes that related
entities may enter into bona fide cost sharing arrangements and
that such arrangements can affect transfer prices. Under
paragraph 7.1.1 of the Guidelines, cost sharing arrangements are
to be taken into consideration in making transfer price income
allocations between the entities involved in the arrangement.
However, full costs, direct and indirect, must be calculated and
included under a recognized accounting method. If the cost
sharing arrangement is to be recognized, the services must be
distinguishable and the aggregate of the costs must be separable
as to the services. No profit is permitted in such an
arrangement. Furthermore, a taxpayer seeking a deduction for a
cost sharing payment must have "a specific right, definite both
in nature and scope, to benefit from the activities of the
central organization."
The experience of the Office of the Assistant Commissioner
(International) has been that, if the comparable uncontrolled
price method cannot be utilized, the German tax authority
generally allows a price or royalty that leaves the enterprise
with an acceptable commercial profit from the sale or license.
^5 Jacob, The New "Super-Royalty" Provisions of Internal
Revenue code 1986: A German Perspective , 27 European Taxation
320 (1987).
- 7 -
although there are no published industrial safe harbor profit
norms. With respect to the transfer of intangibles, the tax
authority does not consider that the intangible property itself
was used when a person acquires the goods or merchandise produced
with the intangible.
JAPAN
Article 65-5 of Japan's Special Taxation Measures Law is
effective for taxable years beginning on or after April 1,
1986.^' This law applies only to corporations (and certain other
legal entities recognized under Japanese law), but does not apply
to individuals, unincorporated joint ventures, and similar
entities. Furthermore, Art. 66-5 applies only to transactions
between a foreign corporation and a corporation that is subject
to Japanese tax and only when the two entities are related by at
least a 50 percent direct or indirect ownership.
Article 66-5 is as follows:
(1) In the event that, during a business year
commencing on or after April 1, 1986, a corporation
("Corporation A") has conducted sale or purchase of
assets, provision of services or other transactions
with a foreign affiliated corporation ("Corporation B" )
which has a relationship with Corporation A in which
one of the corporations in question, directly or
indirectly, owns a number of shares comprising 50
percent or more of the total number of issued shares of
the other one or has any other special relationship
with Corporation A ( "Special Relationship" ) and, in
connection with such above mentioned transaction
("Transaction"), if the amount of consideration of
which payment was received by Corporation A from
Corporation B was less than an arm's length price, or
if the amount of consideration which Corporation A paid
to Corporation B was greater than an arm's length
price, then, for purposes of corporate income taxation
of Corporation A for the said business year, the
Transaction will be deemed to have been carried out at
an arm's length price.
Paragraph (2) of Article 66-5 lists the methods by which the
arm's length price is to be determined, although in contrast to
section 1.482-2(e)(l)(ii) the methods are not prioritized as t-
o
^' Japan Special Taxation Measures Law, art. 66-5 (March 31,
1986), an outline of which is contained in Appendix I, to the
Speech of Toshiro Kiribuchi, Deputy Commissioner (International
Affairs), National Tax Administration, at the International Tax
Institute Seminar, New York, N.Y. (June 2, 1986).
- 8 -
the order In which they must be employed. In the case of sale or
purchase of inventory assets, the permissible methods are
comparable uncontrolled price, resale price, cost plus, and, if
none of the first three methods may be applied, a method
"similar to" the first three methods or "other methods prescribed
by cabinet order." In the case of other transactions ( i.e, ,
that do not involve the sale or purchase of inventory assets),
the arm's length price is determined by "a method which is
equivalent to" the comparable uncontrolled price method, the
resale price method, the cost plus method, and, if none of the
first three methods may be applied, a method "equivalent to" or a
method which is "similar to" one of the first three methods.^'
The comparable uncontrolled price method is described
generally as the price that would have been paid between a buyer
and a seller who are unrelated, where the sale or purchase of
inventory is the same type of inventory as the inventory involved
in the subject transaction, and the circumstances, including
commercial level and transaction volume, are similar. It is
permissible to use this method where the transactions are not
precisely comparable, but it is possible to adjust for
differences.^ *
The resale price method is described as the price computed
by deducting a normal amount of profit (meaning an amount
computed by multiplying the resale price by a normal profit
percentage ) from the amount of consideration when a buyer of
inventory assets involved in the subject transaction resells
inventory assets to a person with which it has no special
relationship.^ '
The cost plus method is described as the price computed by
adding a normal amount of profit (meaning an amount computed by
multiplying the amount of costs by a normal profit percentage),
to the amount of the costs of the seller to acquire, by purchase,
manufacture, or other acts, the inventory assets involved in the
subject transaction.^"
The guidance given by the Japanese legislation for
determinating an arm's length price for the transfer of an
intangible asset is that methods similar to comparable
^^ Special Taxation Measures Law, art. 66-5, §2(i) and (ii)
^" Special Taxation Measures Law, art. 66-5, S2(i)(a).
^' Special Taxation Measures Law, art. 66-5, S2(i)(b).
^° Special Taxation Measures Law, art. 66-5, S2(i)(c).
- 9 -
uncontrolled price, resale, and cost plus methods can be used,
and that, if none of these methods is applicable, a fourth method
may be used.
A unique aspect of Japan's transfer pricing law is a pre-
confirmation system whereby a Japanese parent or subsidiary may
request pre-approval of a sale or purchase price from a foreign
related entity from the tax administration. The purpose for this
procedure is to reduce the number of transfer pricing cases and
to eliminate uncertainties in international transactions. No
such procedure is available under U.S. law, and the IRS would not
grant such a ruling because of the factual nature of the issue.
The Japanese experience to date is that taxpayers are taking a
"wait and see" attitude towards the pre-conf irmation procedure.^ ^
UNITED KINGDOM
The statutory basis under U.K. law for adjustments to
transfer prices is section 770 of the Income and Corporation
Taxes Acts of 1988 [ICTA]. This section provides that where any
property is sold and;
( a ) the buyer is a body of persons over whom the
seller has control, or the seller is a body
of persons over whom the buyer has control ,
or both the buyer and the seller are bodies
of persons over whom the same person or
persons has or have control ; and
(b) the property is sold at a price ("the actual
price" ) which is either --
(i) less than the price which it
might have been expected to fetch
if the parties to the transaction
had been independent persons
dealing at arm's length ("the arm's
length price"), or
(ii) greater than the arm's
length price,
then, in computing for tax purposes the income, profits
or losses of the seller where the actual price was less
than the arm's length price, and of the buyer where the
2 1 Go, Kawada, Director, Office of International
Operations, National Tax Administration, Remarks at the
International Tax Institute Seminar, New York, N.Y. (June 27, 1988
- 10 -
actual price was greater than the arm's length price,
the like consequences shall ensue as would have ensued
if the property had been sold for the arm's length
price, ^^
This section applies to rentals, grants and transfers of rights,
interests or licenses, loan interest, patent royalties,
management fees, payments for services, and payments for goods.
Guidance with respect to application of section 770 of the
ICTA is provided in Notes published by Inland Revenue.^ ^
An Inland Revenue Note defines "arm's length price" as the
price which might have been expected if
the parties to the transaction had been independent
persons dealing at arm's length, i.e. dealing with each
other in a normal commercial manner unaffected by any
special relationship between them.^*
The Note dealing with methods of arriving at arm's length
prices is as follows:
In ascertaining an arm's length price the Inland
Revenue will often look for evidence of prices in
similar transactions between parties who are in fact
operating at arm's length. They may however find it
more useful in some circumstances to start with the re-
sale price of the goods or services etc. and arrive at
the relevant arm's length purchase price by deducting
an appropriate mark-up. They may find it more con-
venient on the other hand to start with the cost of the
goods or services and arrive at the arm's length price
by adding an appropriate mark-up. But they will in
practice use any method which seems likely to produce a
satisfactory result. They will be guided in their
search for an arm's length price by the considerations
set out in the OECD Report on Multinationals and
Transfer Pricing. (This Report examines the
considerations which need to be taken into account in
2 2 Income Tax Acts of 1988, §770.
2 3 Thomas, Richard, Deputy to Assistant of Taxes, Board of
Inland Revenue, Remarks at the International Tax Institute
Seminar, New York, N.Y. (June 27, 1988).
2* The Transfer Pricing Of Multinational Enterprises, Notes
by the UK Inland Revenue (Jan. 26, 1981), at 1, reprinted in
Int'l Bureau of Fiscal Documentation, Tax Treatment of Transfer
Pricing (1987).
- 11 -
arriving at arm's length prices in general and also in
particular in the context of sales of goods, the
provision of intra-group services, the transfer of
technology and rights to use trade marks within a group
and the provision of intra-group loans ).2 5
2 5
Id. at 3
APPENDIX D
AN EMPIRICAL ANALYSIS OF THE MARKETPLACE FOR INTANGIBLES
A. Introduction
One question that has been raised during the preparation of
the paper is whether the requirement for periodic adjustments in
certain situations is consistent with the manner in which
unrelated parties structure arrangements involving transfers of
intangibles. Additionally, the Congressional concern about
related party use of inappropriate comparables raises questions
about which characteristics of unrelated party arrangements
should be included in related party arrangements. This appendix
draws upon academic work that examines actual licensing
experience by unrelated parties in an effort to address this
issue. ^ Although each of the papers examined had a different
goal, the underlying data collected through surveys or
interviews with licensees and licensors provides relevant
information about what unrelated parties do.
In addition to synthesizing other authors' work on
technology transfers, the Service and Treasury have collected a
sample of license agreements drawn from the records of the
Securities and Exchange Commission ("SEC"). The SEC requires
that companies disclose license agreements that are "material" to
the operation of the company.^ The disclosures to the SEC
provide a potential data base of over five hundred agreements.
Only sixty of these agreements have been analyzed for this
report. The choice of agreements in the sample was largely
dictated by the ease of discovery and the availability of
documents within the SEC's files. The sample consists of forty
agreements for the manufacturing industry, most of which are
clustered in the Standard Industrial Classifications (SIC) for
pharmaceutical preparations, toilet preparations, electronic
computing equipment, semiconductors, surgical and medical
equipment, and ophthalmic goods. The other twenty agreements are
for the services industry, mostly within the SICs for computer
programming, computer software, and research and development
laboratories.
^ Authors who rely on statistics that include related
party transactions are quick to point out that the numbers are
biased due to potentially tax motivated manipulations. See ,
e.g. , Katz and Shapiro, How to License Intangible Property , 101
Quarterly Journal of Economics 567-589 (1986).
2 "Material" is an accounting concept that describes items
about which a prudent investor ought reasonably to be informed.
For an explanation of a "material contract," see Item 10 of the
Instructions to the Exhibit Table for Form 10-K, 17 C.F.R. § 229.601
- 2 -
In this study, the SEC doctunents have been used primarily
for further illustration of the points raised by other authors.
Further examination of the SEC agreements will be conducted
after publication of this study, with a view toward relating them
to financial accounting and tax data of the firms involved, and
publishing the results. An analysis of available data might give
a more complete picture of the incomes realized by the two
parties to the transaction and suggest criteria for determining a
profit split in comparable cases.
B. Goal of Licensing Agreements
Parties contemplating entering into a license agreement are
ultimately concerned with the income they can expect to receive
from the arrangement. The existence of proprietary knowledge
suggests that production and sale of the product will result in
profits that are greater than those necessary to provide a normal
rate of return to the inputs provided by both parties. The
actual division of these profits will depend on each party's
forecast of the total profits, and on the relative bargaining
strength of the two parties.
Some authors have formally diagrammed and discussed the
negotiating range of unrelated parties.^ The basic premise is
that the parties are concerned with the split of the net income
from the product. Baranson reports that Bendix officials
"indicated that, if a broad cross-section of American industry
were polled, one would find that the average goal is a return to
the licensor equal to about one-third of the profit of a well-
run, well-established licensee with a broad market."* Caves et
al. find that the licensor will capture an average of forty per
cent of the expected profits that remain after the deduction of a
normal return on capital. According to their sample, the range
of the split leaves one-third to one-half of the profits to the
licensor.^ Contractor's overview of the literature suggests
that licensors "should settle for a 25 to 50 percent share of
the licensee's incremental profit."'
These averages can not necessarily be used to replicate an
individual arm's length deal because they do not, for example.
^ See , e.g. , F. Contractor, International Technology
Licensing , at Chapter 3 (1981).
* J. Baranson, Technology and the Multinational 64 (1978).
' Caves, Crookell, and Killinger, The Imperfect Market for
Technology Licenses , 45 Oxford Bull, of Economics and Statistics
249, 258 (1983).
' Contractor, supra n. 3, at 125.
- 3 -
control for the specific economic activities undertaken by the
parties. They do show that unrelated parties enter negotiations
for a license agreement with expectations about the total profits
that they think will be earned from the exploitation of the
intangible, and about the share of the profit that they can
expect to receive.
C. Payment Terms for a License
Although the goal is to capture a portion of the profits,
the provisions in license agreements rarely specify that a
percentage of the profits will be paid as compensation for the
right to exploit the intangible. This may be because the
licensor fears that the accounting for profits can be
manipulated too easily by a licensee, who may be able to choose
what costs are included. Instead, a royalty that is a percentage
of the net selling price is typically chosen.' Fifty-eight
percent of the agreements in the SEC sample used a royalty based
on the net selling price.® This means of achieving the split of
profits from the intangible leads to a more easily verifiable
number for the licensor.
Of the SEC agreements that have royalties based on the net
selling price, 40 percent have a constant royalty rate. Because
costs vary over time, a flat royalty rate will lead to a
different profit split on a year-by-year basis. Therefore, an
examination of the returns over the lifetime of the agreement is
necessary to determine the true division of the profits.
Some agreements apparently attempt to even out the returns
earned by varying the royalty rate. A number of different
structures are possible. Some agreements have a royalty rate
that declines over time; others are structured so that the rate
rises and then falls. Thirty per cent of the SEC agreements
that have royalties based on the net selling price vary the
royalty rate over the years of the agreement.
The remaining 30 percent of agreements with royalties based
on the net selling price vary the royalty rate based on total
' The net selling price is typically the price charged by
the licensee to unrelated parties on an f.o.b. factory basis
after deduction for state and local sales taxes and, sometimes,
after deduction for quantity discounts.
• Recall that the sample size is small and was not chosen
randomly. All percentages provided are purely illustrative and
should not be accorded the weight one would give to a larger,
randomly selected sample.
- 4 -
sales of the product. This structure may be most clearly tied to
the returns that the licensor requires. It may also provide
incentives to the licensee; this aspect will be discussed below.
Not all compensation packages are based on a percentage of
the net selling price. Eighteen percent of the agreements in
the SEC sample require a royalty per unit. Once again, the
royalty per unit may be constant or it may change as more units
are sold. In the SEC sample, 60 percent of the royalties per
unit were constant, and 40 percent declined per unit as the
number of units increased. The licensor may prefer to base the
royalty on units sold instead of on net selling price if the
licensee is contemplating discounts or if the intangible may be
sold as part of a larger package, such as when software is
distributed free of charge to the buyer of a computer. In the
SEC sample, 80 percent of the royalty per unit agreements
occurred in licenses for computer software. Computer software
would seem to be the type of product for which "free" samples may
be provided or which may be part of a package deal. Indeed, 67
percent of the sample agreements in the SIC code for "Computer
Programming and Software" contain royalties per unit.'
Some agreements combine advance or lump sum fees with a
royalty based on sales or units. Different factors might explain
these payments in different settings. If the licensee's country
of incorporation limits the allowable royalty rate, an initial
lump-sum fee might be used to ensure that the licensor earns the
required return.^ ° Alternatively, the goal of a front-end fee
may be to lower the licensor's risk by ensuring a minimum return.
In the SEC sample, 16 percent of the agreements with per unit or
net selling price royalties also have initial lump sum fees.
Another means of lowering the licensor's risk is for the
licensee to prepay a nonrefundable amount of money against which
future royalty obligations are credited. In addition, a minimum
payment may be due each year. If the total royalties paid are
less than this amount, the licensee must pay the difference to
the licensor. Forty-seven percent of the agreements with per.
unit or net selling price royalties contain this type of
arrangement.
I
' This product specific use of a certain type of royalty
base is the type of information that one would hope to find in
more situations after a thorough examination of the SEC data.
^° If the licensee's country of incorporation intends to
limit the compensation flowing out of the country, attempts to
provide a lump sum payment may only serve to shift the analysis.
In addition to limiting the royalty rate, the country may also
challenge the lump sum payment.
- 5 -
Finally, a lump sum fee may provide the sole compensation
for the use of an intangible for a certain number of years.
Twenty percent of the SEC agreements used a one time, lump sum
payment or annual lump sum payments. Such an arrangement fixes
the return that the licensor will receive. This payment scheme
leaves the licensee to absorb all the variance in the amount
earned. Just as in the minimum payment scheme, if the product is
much less popular than expected, the licensee will absorb the
loss. However, unlike the minimum payment scheme, if the product
is much more popular than expected, the licensee will reap all of
the unexpected rewards. This type of arrangement could provide a
strong incentive to the licensee to concentrate resources on
selling the product.
Forcing the licensee to absorb the risk may not be the only
reason that lump sum fees are chosen. The licensor may have
patented a new technique or instrument that the licensee wishes
to use to attempt to create another product. In this case there
is no readily apparent unit to be produced, nor is anything being
sold initially. Therefore, a lump sum fee may be the only
practical means of compensating the licensor for the use of the
patent. Lump sum fees may also be used to settle disputes over
patent infringement claims.
D. Provisions Which May Affect Returns
Other clauses in the agreement, which do not explicitly
affect payment, may affect the returns earned by the licensor and
the licensee. For example, the licensor may require the licensee
to perform a certain amount of marketing. This clause can be
very specific, and may require that a certain amount be spent or
that a certain percentage of the licensee's marketing
expenditures be devoted to the licensor's product.^ ^
Alternatively, the marketing or advertising clause may be open-
^^ One agreement states that:
[I]n each License Year during the term of this
Agreement, Licensee shall expend a sum equal to 2%
of the Net Sales of Licensed Products ... for trade
and consumer advertising of Licensed Products
under the Licensed Trademarks. All such
advertising shall be in accordance with the
provisions of this Agreement. Licensee shall
furnish Licensor with copies of each such
advertisement and with proof of such advertising
expenditure.
The agreement goes on to define advertising and to require that
"such advertising shall have been submitted to Licensor and
received its prior written approval."
- 6 -
ended, requiring that the licensee use its "best efforts. "^^
Although such a clause does not readily translate into a dollar
figure, it potentially gives the licensor the ability to
terminate the agreement or to file suit if unsatisfied with the
results.
One might expect to find these clauses in licenses for
products in which advertising plays a pivotal role in determining
the success of the product. Indeed, in the SEC sample, these
marketing or advertising clauses seem to be particularly
prevalent in the SIC code for toilet preparations. Seventy-
three percent of the agreements in the SEC sample that contain
advertising clauses are for licenses with respect to clothing
articles or toilet preparations. Once again, certain features of
agreements seem to be product specific. This suggests that a
comprehensive analysis of the marketplace for intangibles should
ideally focus on individual product groups.
In addition to lowering the licensor's risk, these marketing
clauses imply that the licensee is engaging in a significant
economic activity beyond the manufacture and distribution of the
good that embodies the intangible. One would expect that the
performance of this additional activity would affect the returns
that each party anticipated.
A major factor affecting the licensor's return from
licensing the intangible is the amount of technical support
required as a condition of the license. The total expense of
transferring a technology to a licensee will depend on the
technology and on the licensee's level of expertise. Transfer
costs include the physical transfer costs of plans,
specifications, and designs, as well as the cost of training the
licensee to make use of them. Since the licensor has typically
already created the product being licensed, the cost of
transferring the technology may be the biggest resource cost to
the licensor. Indeed, Contractor finds that the most important
factor in determining the licensor's return on an agreement is
the amount of technical services provided.^ ^ By carefully
limiting the amount of service automatically provided, the
licensor can minimize uncertainty of return from the transfer.
^2 One such clause reads: "[Licensee] shall use its best
efforts to document, package, market, distribute, advertise and
promote the Use of the Software. All advertising and
promotion. . .shall be undertaken at [the licensee's] expense....'
^^ Contractor, supra n. 3, at 123, n. 6.
- 7 -
Additional technical support is sometimes provided on a time
and expense basis. ^* The split between "free" technical support
and additional support for which the license is charged varies
depending on the circumstances. Additional detail would be
necessary to test hypotheses concerning how expectations about
technical support affect technical assistance provisions and how
these provisions affect the whole licensing package. The SEC
data reveal a variety of solutions to the technical assistance
question. Some set a specific time period for "free" technical
support.^* Others require that technical assistance be
reimbursed at cost,^' at a fixed rate,^^ or at the lowest rate
charged by the licensor to third parties.^' As is true of the
1 4
Baranson, supra n. 4, at 65, n. 4
^^ A license for the design, use, and sale of laser
accessories with a per unit royalty provides:
Upon [licensee's] request, [licensor] shall give or
shall cause to be given to [licensee] such technical
assistance and shall give or shall cause to be given to
[licensee's] employees such training for 6 months after
the date hereof as [licensee] may reasonably require
in connection with the transfer of technology provided
in the preceding paragraph. . . .
^* A license to manufacture and sell clothing using the
licensor's trademark with a royalty based on net sales notes:
Licensor agrees to furnish technical aid to the
licensee (including information concerning advertising,
packaging and customer lists) if requested in writing,
provided that the licensee pays all of the expenses for
such aid. . . .
^' A 1985 license agreement to modify and sell software
where the license makes regular, fixed royalty payments says: .
[Licensor] agrees to provide technical assistance
concerning the Software to licensee, upon request by
Licensee, in the development of the Modified Software;
provided, however, that in addition to all other sums
payable under this Agreement, Licensee agrees to pay
[licensor] the sum of SIOO.OO per hour for all labor
provided by [licensor], plus reimbursement for all
expenses incurred by [licensor] in providing such
technical assistance to Licensee.
1" A license for the use of a new type of laser where the
licensee provides fixed annual royalty payments requires:
- 8 -
marketing clauses In a licensing agreement, a licensor may need
to balance the desire to push all of the technical costs onto the
licensee with the need to ensure that the licensed intangible is
used productively.
E'. Preparing for Surprises
An arm's length license agreement is shaped by each party's
expectations about costs, sales, and the overall profit potential
from the use of the intangible. The parties' expectations may
differ, and they may differ markedly from the actual profit
experience with the product. Therefore, even if both parties are
pleased with the royalty rate to be paid, the level of technical
services to be provided, and any marketing clauses or clauses on
market restrictions, it is possible that future events will leave
one or both of the parties dissatisfied with the arrangement.
There are two types of surprises from which the parties may
desire protection. One surprise occurs if further development of
the intangible significantly improves the product's
profitability. The other occurs if several years of actual
profit experience lead to a change in expectations about future
profitability.
The first surprise is of particular concern to the licensor.
In order to insure against this risk, many license agreements
contain "grant back" or "technology flowback" clauses. These
clauses specify that the licensor receives, free of charge, any
enhancements to the technology that are developed by the
licensee. These clauses serve to discourage the licensee from
doing its own R&D and potentially competing with the licensor.
They further protect the licensor from losing out on
serendipitous discoveries by the licensee. Caves et al . found
grant back clauses in 43 percent of the 257 agreements they
studied. However, the clauses appeared 76 percent of the time
in agreements involving "dominant product" licensors.^'
[Licensor] shall make available such technical
assistance as [licensee] may reasonably request for
understanding or exploiting the Proprietary Technology
at [licensor's] standard rates, and under terms that
are no less favorable than those extended to any of its
other customers.
^' Caves, supra n. 5, at 261, n. 5. A dominant product is
one that accounts for more than 60% of a firm's sales. This
classification relates only to the level of the firm's
diversification. It does not make any distinction with regard to
the overall profitability of the product. Id. at 252.
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The second type of surprise, changes in the parties'
expectations about future profitability, can create problems from
which both licensors and licensees may want relief. Termination
clauses provide one kind of protection in these circumstances.
In one agreement, a license for the use of a trade name, the
licensee was required to meet certain sales targets. This type
of arrangement allows the licensor to exit from the deal or
renegotiate if the volume is insufficient to realize the expec.ted
returns from the intangible.
In other cases, termination clauses allowed the parties to
end the contract, without cause, after giving notice. This
safety valve may not lead to actual termination but instead may
offer an opportunity for renegotiation if one of the parties
thinks that its returns are inadequate. The structure of
termination clauses varies. Clauses may allow immediate
termination, or they may require several years' notice.
Manufacturers' distributors can typically be dropped by the
manufacturer to whom they are under contract on 30 days'
notice.^ ° At the other end of the spectrum, some terminations
without cause are tied to the length of a patent. However, not
all agreements involving patent life specify such a long period
before renegotiation is considered. Thirty-four percent of the
SEC agreements provide for termination without cause for the
licensee, while 21 percent allow the licensor to terminate
without cause after a given period of time.
Some agreements have no termination clause except for cause.
There are several situations in which a license might be likely
to lack a termination clause. If the licensee was required to
make a substantial initial investment in order to make use of the
intangible, one can hypothesize that the licensee would not enter
into the agreement if the licensor could easily pull out of the
deal. Another type of agreement without a termination clause
might be one involving the license of products, such as computer
software, that have a very short lifespan. In this case the
relevant life is so short that termination is not a useful
option; both parties must choose correctly the first time.
Related to this group are agreements that are scheduled to end
after a specific, and relatively short, length of time. These
agreements will automatically be renegotiated if the parties wish
to extend the license.
Fifty-five percent of the SEC sample agreements allow no
termination except for cause. However, of this subset, 22
percent are agreements that have a specified length of less than
2° Galante, Quickie Divorce Curbs Sought By Manufacturer's
Distributors, Wall Street Journal, July 13, 1987, at 25.
- 10 -
three years, and another six percent are agreements of five or
six years in duration. These agreements seem to fall into the
category of licenses with relatively short lengths.
Twenty-eight percent of the SEC sample agreements without a
termination clause (16 percent of the total sample) were
agreements with a duration of ten years or more. More
information on these licenses would need to be gathered in order
to test the hypothesis that extended licenses tend to exist when
the licensee is required to make a substantial initial
investment. 2^
Of the remaining agreements with no termination clause, 22
percent were for agreements with lump sum payments and 22 percent
were for agreements of indeterminate length. The latter group
typically specified that the agreement lasted until the patent
expired; these patent expiration dates were not readily
available. ^^
The existence of termination clauses shows that companies
are concerned about their ability to predict the total profits
from the exploitation of an intangible. Regardless of the
existence of termination clauses, agreements do get renegotiated.
The frequency of renegotiation would give information about the
"surprises" that occurred and the companies' ability to predict
the outcome of a license agreement. Although it is not possible
to make general statements about the overall frequency of
renegotiations or terminations based on the sample of agreements
we examined, some examples of renegotiations were found. A
license to manufacture and sell clothing under a trademark was
renegotiated in the second year of a six year term. The amended
agreement provided the licensor with a royalty rate, based on net
selling price, one percentage point higher than the original
rate. However, the new agreement also lowered the percentage of
the net selling price to be spent by the licensee on advertising
by one-half a percentage point.
Other agreements provide clear evidence that the parties •
contemplated the possibility that renegotiation might be
necessary. One agreement, with no termination clause, provides
for renegotiation of the royalty rate after three years. At that
^^ In addition, representative information on all
licenses, regardless of term, that require the licensee to make a
substantial investment would be necessary in order to test the
hypothesis that a large initial investment by the licensee leads
to a license of long duration.
2 2 These agreements could be of short duration; several of
the other license agreements in the sample were for patents with
only two or three years left before expiration.
- 11 -
time, "[B]oth the royalty rate and the scope of the Patented
Portions will be renegotiated. . . [to] aggregate to not less than
1.5 percent and not more than 2.5 percent of the Royalty Portion
selling price of such Licensed Products." Another agreement
provides for renegotiation after certain events occur, instead of
after a certain time period. This is a 15 year agreement which
the licensee can terminate on six months' notice. It says:
"Licensor or Licensee are unable at the Effective Date of this
Agreement to value on a proportionate basis the future worth to
Licensee of the rights presently owned by Licensor in the
Technological Field...." The agreement goes on to provide for
current royalty payments and for additional payments, depending
on the outcome of certain events.
This discussion of terminations and renegotiations shows
that there is no single way of dealing with uncertainty.
Ultimately, much more detailed analysis would have to be
undertaken to determine what circumstances lead unrelated parties
to renegotiate or terminate contracts.
F. Conclusions and Recommendations
The agreements filed with the SEC and those analyzed in the
academic work provide a body of information concerning arm's
length transactions involving intangible property. This body of
information points out key factors that should be considered when
determining the proper allocation of income in related party
situations. The SEC data and other sources will be further
analyzed in greater detail following publication of this paper.
For example, patterns might be disclosed between royalty rates
and specific levels of technical assistance, or marketing
expenditures, either in general or by specific industry groups.
Moreover, a study of the prevalence of, and circumstances that
trigger, termination or renegotiation clauses (as well as the
results following exercise of the clause) might be helpful in
determining when unrelated parties exercise these rights.
APPENDIX E
EXAMPLES OF METHODS FOR VALUING TRANSFERS OF INTANGIBLES
Preamble to Examples
The examples that follow illustrate the principles and
methods described in Chapter 11. They are intended to set forth
what the Service and Treasury believe is an ideal application of
these principles and methods to specific factual situations.
They are intended to serve as guidance for taxpayers in planning
their pricing transactions as well as for both taxpayers and the
Service on audit. In large part, the types of information set
forth are based upon information used by lEs and economists on
audit and used by taxpayers or outside economists for planning
purposes.
In general, it is expected that the amount of information
about comparable transactions, rates of returns, and costs for a
taxpayer's industry and claimed comparable transactions will be
the greatest following a full examination of the taxpayer's
return. But, as Chapter 3 makes clear, taxpayers have a burden
to document contemporaneously, and to justify, their transfer
pricing policies and their return positions. The Service and
Treasury recognize the practicalities involved in locating and
analyzing the type of information set forth in certain of these
examples when transactions are planned or returns filed. In
general, the taxpayer making a relatively minor investment would
not be expected to have gathered and analyzed data outside of its
own knowledge of its business affairs and those of its
competitors. As Chapter 3 indicates, however, a taxpayer
engaging in a transaction involving high profit intangibles
should arguably be expected to gather and analyze the type of
information set forth in certain of the examples, to the extent
that it is available, contemporaneously with the transaction.
Example 1 : Exact Comparable
Hydrangea, Inc. is a U.S. developer, producer, and marketer
of business software for personal computers. It has developed a
new line of specialized accounting software that it expects to
sell mainly in foreign markets.
Hydrangea expects that this product will have a life cycle
similar to most other products in its line. Thus, it expects
that this software will have a peak productive life of three to
five years. If it is moderately successful, there will be a
small, declining market after that, as obsolescence sets in. If
- 2 -
the product is very successful. Hydrangea may decide to develop
an enhanced, substantially modified version after the peak
period, which it would treat as a new product.
Hydrangea has decided to serve the market in country F for
this software by licensing it to an unrelated country F
corporation, Fleur, with which it has had satisfactory dealings
in the past. Specifically, Hydrangea and Fleur have negotiated a
licensing agreement with the following terms. Fleur receives an
exclusive license to market Hydrangea's product in country F and
agrees to pay Hydrangea 20 percent of the net selling price for
each copy it sells. Fleur agrees not to market competing
products while the license is in effect. Fleur will market the
product under its brand name and will perform the necessary work
to modify the product to integrate it into its own line of
accounting software. Hydrangea agrees to provide Fleur, for
free, with any corrected, revised, and enhanced versions of the
software that it releases publicly during the first four years.
(Fleur and Hydrangea understand that, after that period, the
latter is permitted to develop an enhanced, substantially
modified product and to call for new negotiations with Fleur,
find another licensee, or market the new product itself. ) The
agreement grants Fleur a perpetual license to the current
product. During the first four years, neither party can
terminate without cause; after that period, Fleur can terminate
with six months' notice.
Hydrangea will serve the market in country B through its
wholly owned local subsidiary. Royal Hydrangea. The markets in
countries F and B are substantially similar in size,
sophistication, and ability to use business software intended for
personal computers. Royal Hydrangea performs the same functions
as Fleur relating to marketing and distribution of accounting
software. Thus, it will modify the product as necessary for
local requirements; it has been and will continue to be
responsible for marketing its products and developing its
trademark; and, it maintains a distribution network, including a
sales staff. For these reasons. Hydrangea concludes the external
standards for using the Fleur agreement as an exact comparable
are satisfied.
Hydrangea satisfies the internal standards by including all
important features of the Fleur agreement in its agreement with
Royal Hydrangea. Thus, the royalty is set at 20 percent of net
selling price. The provisions concerning corrections and
revisions are also, therefore, included, as are the provisions
concerning duration and termination.
Each year. Hydrangea reexamines its related party
arrangement to determine if the exact comparable approach is
still valid. Specifically, it determines whether the two markets
are still similar, and whether Fleur and Royal Hydrangea still
- 3 -
perform similar functions. If these aspects of the external
standards have substantially changed, or if Fleur terminates its
agreement. Hydrangea must reestablish the appropriateness of its
related party transaction, which may require adjusting the
royalty rate.
Example 2: Unavailability of Comparables
A U.S. company has developed a unique good that it believes
will capture 80 percent of the relevant market. The U.S.
company plans to produce the good in the United States and to
license the rights to production and sale for the rest of the
world to its foreign subsidiary. The U.S. company can find no
examples of situations in which an unrelated party licensed the
rights to production for a product that captured such a large
share of the market. Therefore, the company should use the
arm's length return method in order to set the appropriate
royalty rate with its foreign subsidiairy.
Example 3: Inexact Comparable
Shampoo Inc., a well known hair-care products corporation in
the United States, plans to set up a subsidiary in country Z in
order to introduce its line of products in country Z. The
subsidiary will manufacture, distribute, and market the products
using the Shampoo trademark. When planning the appropriate
transfer price for the license. Shampoo officials started with
the knowledge that one of their competitors. Condition Corp.,
licensed a line of hair-care products to an unrelated party in
country Z, Lotions, Inc.
The Condition license covers the formulas for all of
Condition's hair-care products as well as the Condition
trademark. The license gives Lotions the right to manufacture,
distribute, and market the licensed products. Terms include an
exclusive license in country Z for a term of four years paying a
royalty of four percent of the net selling price. The licensor
agrees to provide the licensee with product formulations,
scientific data, manufacturing know-how, marketing, public
relations, and related assistance. The licensee must adhere to
strict quality control standards in manufacturing, distribution,
and marketing. The licensor has the right to inspect operations
of the licensee to verify such quality. The licensee is
prohibited from manufacturing, importing, or marketing competing
products in country Z.
From the terms of the agreement it is clear that Lotions
performs the same functions that Shampoo's subsidiary in country
Z will perform. It is also clear that Condition provides the
same type of services and quality control for Lotion's
operations that Shampoo will provide for its subsidiary in
country Z. It is anticipated that Shampoo's subsidiary will have
- 4 -
a volume of sales similar to Lotion's once its operations are
fully developed. Finally, Shampoo knows that the gross margin,
(net sales - cost of sales) /net sales, on sales of Shampoo's
products in the United States is similar to the gross margin
achieved by Condition in the United States, which indicates that
their manufacturing processes and sales activities have
comparable efficiencies. Therefore, it is appropriate for
Shampoo to set a royalty rate of four percent of the net selling
price for a four year term.
Example 4: Likely Use of Inexact Comparables
Computers Inc., a U.S. software company that specializes in
games, plans to acquire the rights to manufacture, market, and
distribute a new computer game. Gizmo, created by its European
subsidiary. Gizmo will be an addition to Computers' existing
line of games. Computers Inc. projects that the total number of
Gizmo copies distributed will be close to the industry average.
Numerous third party licenses for computer software are
available. Computers examines these licenses for appropriate
inexact comparables and should be able to determine the
appropriate royalty amount and other terms for its agreement with
its affiliate from the third party agreements.
Example 5: Basic Arm's Length Return Method: U.S. Importer and
Distributor
TravelFun is a large publicly traded foreign corporation
with a U.S. subsidiary, TravelUS. TravelFun produces a unique
recreational product using sophisticated and highly sought-after
production technology. TravelUS imports the assembled product
and distributes it under the Travel name. TravelUS has the
exclusive right to develop the Travel name in the United States.
Because of the importance of the intangibles, TravelUS must apply
the rules governing the transfer of intangible property.
TravelFun does not license the Travel name to unrelated
parties, nor does it allow unrelated parties to distribute the
product. Therefore, no exact comparables are available. Similar
products exist that could potentially serve as inexact
comparables; however, none of them are sold to unrelated
distributors. Therefore, when TravelFun sets up its policy for
transfer prices of units sold into the United States for 1989 it
uses the rate of return method. In order to apply the method
properly, the following information is necessary: 1) a general
description of the functions that TravelUS performs, 2) financial
information on companies performing similar functions, and 3)
analyses of appropriate rates of return.
1) Functions of TravelUS . TravelUS imports the product from
TravelFun and distributes it to retailers. TravelUS is
- 5 -
responsible for developing the marketing strategy in the United
States.
2) Companies performing similar functions . Initially,
TravelFun seeks data about publicly traded independent operators
of wholesale distribution businesses. A search of the
appropriate SIC categories yields a number of companies that
differ in the following ways: 1) some are importers, while
others acquire their products in the United States; 2) some are
distributors of final products, while others distribute parts;
and, 3) some apply intensive marketing, while others do not.
Examination of these firms' published financial information
indicates that the sample should be narrowed to 16 firms in
order to reflect more clearly the functions performed by
TravelUS. TravelUS is an importer that distributes final
products and performs an important marketing function. Each firm
in the final sample has some combination of these characteristics.
Balance sheet and income data are then collected for the sample
of 16 companies.
3) Analysis of appropriate rates of return . The company
evaluates the available information in order to determine the
appropriate ratios on which to base its comparisons. Comparable
asset data are not available for all firms in the sample.
Therefore, an attempt must be made to determine a rate of return
for TravelUS based on available cost data for the sample of
firms. A number of ratios can be considered as a means of
determining an appropriate return on costs. Possibilities
include the ratio of gross profit to operating expenses (the
Berry ratio), the ratio of operating income to the cost of sales
and operating expenses, and the ratio of net pre-tax income to
total expenses. The choice of the appropriate ratio will depend
on the composition of the sample and the stability of the ratios
over time.
For the sample of 16 companies, all of the ratios lead to
similar results. TravelUS retains the information that supports
this claim, but upon examination presents only the analysis using
the Berry ratio. As defined above, the Berry Ratio is the ratio
of gross profit to operating expense:
Net Sales - Cost of Sales
Operating Expenses
Net sales are total revenue from sales less cash discounts to
customers for payment within a specified time. Cost of sales is
also referred to as cost of goods sold, including freight
charges. Operating expenses include selling expenses such as
sales salaries and commissions, advertising and marketing
- 6 -
expenses, depreciation expenses, supplies, office salaries, and
payroll taxes. The major expense not included in either cost of
goods sold or operating expenses is interest expense.
For the 16 firms in the sample the average Berry Ratio is
1.40 with a standard deviation of .15. (The minimum ratio was
1.17 and the maximum was I.6I0) TravelUS uses the average ratio,
1.40, in order to determine the payment that should be made to
the parent. Additional information that will be necessary
includes net sales, operating expenses, and cost of sales that
are not included in the payment to the parent for the product.
TravelUS projects sales of 20,000 units, net sales revenue
for 1989 of $100 million, and operating expenses of $30 million.
Cost of Sales are projected to be $2 million plus transfer
payments to TravelFun. Plugging this information into the
equation for the Berry ratio yields:
$100 mil. - [$2 mil + 20,000 x ]
1.40 * -■ --■ —
$30 mil
Therefore, x, the transfer price paid for each unit, is $2800.
TravelUS will pay TravelFun $2800 per unit of import and
projects that it will pay TravelFun a total of $56 million in
1989.
Example 6: Basic Arm's Length Return Method: Foreign
Subsidiary Serving Local Market
Counter Inc., a U.S. corporation that specializes in over-
the-counter drugs, plans to set up a subsidiary in country X.
The subsidiary will manufacture, distribute, and market Counter's
products in country Z. The manufacturing process is not
particularly complex. The subsidiary will set up its own
distribution network, which will be of average size for the
industry. Further, it will perform its own marketing; however,
because the subsidiary will, in general, sell "generic" products
that will sell under its customers' brand names and trademarks,
its marketing activities will involve contacting drug stores and
other selling concerns, and not the development of a unique,
consumer- level marketing intangible.
Counter's search for unrelated party licenses for comparable
products proves fruitless. The search does yield a number of
licenses in which the functions performed by each party are
similar. The products are not similar enough to over-the-counter
drugs to be classified as inexact comparables; however, the
level of manufacturing, the type of distribution network, and the
type of marketing performed in each case are similar. Therefore,
Counter searches for information about the returns earned by
each of these companies. Analysis of the income statements and
- 7 -
balance sheets of the firms in the sample yields an average rate
of return earned. This average can be used by Counter to
determine the royalty rate to be paid by its subsidiary in
country Z .
Example 7: Basic Arm's Length Return Method: Foreign Subsidiary
Producing for U.S. Market
A U.S. corporation has developed and patented the formula
for a new heart drug that has fewer potential side effects than
any drug in existence. The U.S. corporation plans to manufacture
the drug in a foreign subsidiary to be located in country Y,
which has very low labor costs. The completed product will be
returned to the parent for sale in the United States. In
addition, some of the manufactured drug will be shipped from the
manufacturing subsidiary to a marketing subsidiary in country X
for sale in Europe, The parent wishes to fashion the transaction
so that a royalty will be paid by the subsidiary to the parent
for the right to manufacture and sell the drug. The parent and
the subsidiary in X will then pay the manufacturing subsidiary
for the finished product.
The following information is known or projected:
1. The drug will sell for $2.00 per pill.
2. The volume of sales in the United States in 1989 will be
approximately 900 million pills.
3. The volume of sales in Europe in 1989 will be approximately
600 million pills.
4. Marketing and distribution costs in the United States are
estimated to be $14.4 million.
5. Marketing and distribution costs incurred by the country X
subsidiary are estimated to be $9.6 million.
6. The manufacturing subsidiary's costs will be as follows:
Cost of Chemicals $110 million
Operating Expenses $ 75 million
License Payments To be determined
All Other Expenses S 5 million
7. The manufacturing subsidiary will have the following assets:
Cash S 12 million
Factory $360 million
- 8 -
8. The manufacturing subsidiary will have the following income:
Interest Income $ 1 million
Revenue from Sale of Drug To be determined
There are no transfers by unrelated parties that would
provide an inexact comparable for either the license the parent
grants to the manufacturing subsidiary or for the pill that is
sold to the parent and to the -marketing subsidiary. There are
other companies that perform similar marketing and manufacturing
functions. The difficult piece to measure is the value of the
patent which is held by the parent. Therefore, the parent turns
to the arm's length return method as the appropriate method. The
parent will find proper rates of return for the manufacturing and
marketing segments of production and allocate to itself the
residual profits.
A sample of manufacturers in locations with low labor costs
shows that manufacturers earn an average rate of return on their
manufacturing assets of 12 percent. The subsidiary's total
manufacturing assets, the factory, cost S360 million. Prices
should be structured so that the manufacturing subsidiary earns
profits of S44.2 million ($43.2 million return on the factory
asset plus the known $1 million return on cash).
If all of the drug were resold to the parent, the split
between the cost of the final pill and the license payment would
be unimportant as long as the correct amount of income remained
allocated to the subsidiary. However, in this case the final
product is also being sold to the subsidiary in country X, so
the correct split is important.
Information on marketers and distributors of drugs shows
that they earn approximately cost plus 25 percent, both in the
United States and in country X. Based on the costs outlined
above, the parent should earn net income of $3.6 million on its
distribution and marketing activities, and the Country X
subsidiary should earn net income of $2.4 million. Revenue from
the sale of the heart drug will be approximately $1800 million in
the United States and $1200 million in Europe. Therefore, the
manufacturing subsidiary should charge $1.98 per pill.
Total revenue received by the manufacturing subsidiary will
be $2971 million (S2970 million from sales and $1 million from
interest income. ) The royalty to be paid to the parent will be a
percentage of the net sale price of $1.98. The correct royalty
rate, r, can be determined by the following equation, which shows
the manufacturing subsidiaries revenues and costs:
- 9 -
Net Income ■ Total Revenue - Cost of Chemicals
($44.2 mil.) ($2971 mil.) ($110 mil.)
- Operating Expenses - Other Expenses
($75 mil. ) ($5 mil. )
- Royalties Paid
[(1500 mil. )($1.98)r]
Solving for r shows that r equals .921.
Therefore, the appropriate royalty rate is 92.1 percent of the
net selling price of $1.98.
Example 8: Likely Use of Basic Ann's Length Return Method
A U.S. company manufactures electronic equipment for sale in
the United States. The U.S. company designs the equipment and
licenses the designs to its foreign subsidiary. The subsidiary
assembles the circuit boards and other components for the
products and sells them to the parent. For transfer pricing
purposes, the parent searches for the rate of return earned by
independent computer assembly operations in order to determine
the amount of income that should be attributed to its foreign
subsidiary.
Example 9: Likely Use of Either Inexact Comparables or Basic
Arm's Length Return Method
A U.S. company manufactures and markets a line of
sportswear. The company plans to introduce the same line of
clothing to Europe through its European subsidiary. The
subsidiary will manufacture, market, and distribute the casual
wear using the parent's trademark. The clothing is marketed
toward middle income consumers and is projected to sell at prices
and earn a market share similar to several other brands which are
marketed to this group. The parent has two options when setting
its transfer pricing policy. If unrelated party licenses of '
trademarks for clothing can be located, then these inexact
comparables can be used to establish appropriate terms for the
license agreement. If information is available on the returns
earned by unrelated parties that perform functions similar to the
European subsidiary, then the rate of return method can be
employed.
Example 10: Profit Split Method using Split Observed in Arm's
Length Transaction
ABC is a U.S. corporation that produces advanced machine
tools. It maintains a large artificial intelligence research
lab, which has made significant advances in computer vision.
Recently, this work has begun to yield marketable products.
- 10 -
Specifically, ABC has developed a "sighted" numerically
controlled machine tool (NCMT) that can be programmed to
recognize the pieces on which it should perform its fabrication
tasks. ABC expects this new device to be a significant advance
over competing NCMTs because the pieces will not have to be
precisely aligned before the fabrication operations can be
performed; therefore, the "sighted NCMT" should be much easier to
operate and integrate into an assembly line. The key element in
this advance is the software that allows the NCMT to determine
the precise position and orientation of a piece placed on its
operating deck. ABC has obtained worldwide patent protection for
this software. As is true of most of ABC's products, the device
must be substantially modified for each customer's specific
application, and ABC maintains a large and expert engineering
staff to accomplish this.
ABC projects that devices based on the new technology will
eventually become an important source of revenues and profits for
the company. During the first three to five years, ABC expects
to have no significant competitors, and plans to market the
devices to the high price, high mark-up, low volume, most
technologically advanced segment of the NCMT market. After that
period, as the technology becomes more common, ABC expects that
sighted NCMTs will, in general, replace other types of NCMTs and
that its lead will enable it to capture a significant share,
perhaps 50 percent or more, of the overall NCMT market.
ABC-Europe is a wholly owned subsidiary of ABC incorporated
in country X. All of ABC's products currently sold in Europe are
produced and marketed by this company. ABC-Europe maintains its
own research and engineering staffs and manufactures all of the
devices it sells. A majority of the products in its line
involve technology licensed from ABC, but a significant fraction
depend on technology developed through its own research efforts.
ABC-Europe performs all of the marketing for Europe, and its
engineering staff performs the necessary development work of the
devices for each customer.
ABC plans to transfer the European rights to exploit the
software and associated technology for sighted NCMTs to ABC-
Europe. ABC has no plans to license the technology to an
unrelated party; therefore, no exact comparable is available.
ABC has conducted a search for inexact comparables; although the
search does turn up unrelated party transactions involving
licenses of machine tool devices and patents, ABC has concluded
that none of them can meet the standards for the inexact
comparable method. Specifically, none of the potential
comparables are for devices which involve profit margins as high
as the sighted NCMTs will have in the short run, nor market
shares as large as ABC anticipates having in the long run.
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ABC next considers the basic arm's length return method. It
concludes that ABC-Europe's activities in exploiting the sighted
NCMT technology can be split into four functions: (a) conducting
research to search for uses in the European market, (b) marketing
the devices, including participating in trade shows, conducting
demonstrations, and providing technical assistance (mass-market
retail-level advertising is not necessary in this industry), (c)
designing the specific devices to meet the requirements of each
customer's application, and (d) manufacturing and distributing
the devices.
ABC concludes that some but not all of these functions can
be analyzed under the basic arm's length return method. Once
each customer's design has been set, manufacture of the devices
will not be much more complicated than current NCMTs, and ABC is
familiar with firms that manufacture current-generation NCMTs
according to others' designs. Therefore, ABC concludes that
function (d) can be analyzed in this way; specifically, it
concludes that a rate of return to operating assets of 16 percent
is the average for firms that perform this function. Marketing
is not a major activity in this industry, because the customers
are extremely knowledgeable. ABC deals with firms that perform
marketing functions for it; based on its knowledge of these
firms, ABC concludes that a 20 percent ratio of income to costs
is a reasonable way to value the contribution of function (b).
Functions (a) and (c), however, cannot be analyzed in this
way. ABC-Europe's staff of scientists and engineers, while
smaller than ABC's, is still one of the largest and most expert
in Europe. ABC knows of no independent firm in the machine tool
industry, in the United States or Europe, that would be able to
conduct research, development, or design work as satisfactorily
as or on a scale comparable to ABC-Europe. Therefore, ABC
concludes that it would be inappropriate to value the
contributions that ABC-Europe's performance of these functions
will make toward selling sighted NCMTs in Europe by multiplying
the assets employed by a rate of return, or multiplying the costs
incurred by an income-to-costs ratio. In short, a profit-split
approach is necessary.
Although ABC's search for comparables did not turn up
appropriate licenses in the machine tool industry, other
transactions between unrelated parties were found. For example,
ABC obtained information about the following transaction: a
group of professors, in partnership with their university,
established a consortium to patent and exploit a process through
which a new product can be produced by a genetic engineering
technique. The consortium bargained at arm's length with several
large chemical companies, and negotiated a licensing agreement
with one of them. The licensee manufactures the product, tailors
it to meet the specific needs of various groups of farmers, and
markets it. The product has no significant competitors and has
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achieved widespread use in certain important agricultural
applications. The licensee pays the university consortium a
royalty of $7 per pound.
ABC next gathers information about the chemical company and
the industry in which it operates. It is able to determine that
the chemical company maintains a large staff of scientists and
engineers which performs functions concerning the new product
that are comparable to the research and development activities
that ABC-Europe will perform. The chemical company undertakes
significantly more marketing activities than will ABC-Europe, and
the manufacturing process for the product is not comparable.
Further, ABC is able to detennine the following information: (a)
the product sells for $27 per pound; (b) production costs are
ten dollars per pound; (c) independent firms that produce
chemicals using similar production techniques earn profits equal
to 20 percent of costs; (d) marketing and distribution expenses
are three dollars per pound, and (e) independent firms that
perform similar marketing and distribution activities earn 33
percent of expenses.
This information allows ABC to determine the profit split
between the basic technology contributed by the university
consortium, on the one hand, and the research, development, and
application activities and know-how contributed by the chemical
company, on the other. Specifically, the latter 's profit per
pound, net of royalty and expenses, is seven dollars ($7 = $27 -
$7 - $10 - $3 ) . Of this amount, two dollars should be attributed
to the manufacturing activity and one dollar to the marketing and
distribution ($2 = SIO x 0.20, and $1 « $3 x 0.33). This leaves
four dollars per unit as the return to the chemical company's
know-how and skills as to R&D and application of technology to
its customers' needs. The university's income is the seven
dollars royalty. Therefore, the profit split is 64 percent (64
percent =7/(7+4)) for the licensor's basic technology and 36
percent (36 percent =4/(7+4)) for the intangibles employed
by the licensee. (Note that the licensor and licensee each earn
50 percent of the total profits, since they each earn seven
dollars per pound; however, 50 percent vs. 50 percent is not the
relevant profit split for this situation, because it does not
distinguish between the profits for the manufacturing and
marketing functions. )
Finally, ABC is able to determine the proper arrangement
for its license to ABC-Europe. There are many ways ABC could
structure the arrangement. One would simply be to specify that
ABC-Europe (a) determine gross profits from sales of sighted
NCMTs (with gross profits defined as sales receipts minus
manufacturing and marketing costs), (b) subtract 16 percent of
the value of assets used in manufacturing the devices, (c)
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subtract 20 percent of the marketing costs, (d) subtract 36
percent of the remainder, and, finally, (e) remit the remaining
amount to ABC as a royalty.
Alternatively, ABC could use additional information about
ABC-Europe's future activities to set a more traditional
licensing arrangement. ABC's projections for sales of sighted
NCMTs in Europe during the first three years of operations
include the following figures. The devices will sell, on
average, for $100,000 each. Cost of production will be $56,000
and will require $50,000 of production assets per device.
Marketing costs will be $5,000 per device. These projections
imply that gross profits, defined as sales receipts minus
manufacturing and marketing costs, equal $39,000 per machine. Of
this amount, ABC-Europe should be allocated $8,000 for the
manufacturing function and $1,000 for marketing ($8,000 * $50,000
X 0,16 and $1,000 = $5,000 x 0.20). Remaining profits are thus
$30,000 per device. This amount should be split 64 percent to
ABC and 36 percent to ABC-Europe; thus, ABC should be allocated
$19,200 per device and ABC-Europe the remaining $10,800. A more
traditional licensing arrangement, therefore, would require that
ABC-Europe pay ABC a royalty equal to 19.2 percent of sales
(19.2 percent - $19,200 / $100,000).
If ABC chooses the former type of arrangement, periodic
adjustments to it are less likely to be necessary, because the
allocation of income between ABC and its affiliate will
automatically adjust to a large extent. ABC should reconsider
periodically, however, whether the manufacturing rate of return
to assets, the marketing income to cost ratio, and the profit
split percentages are still appropriate. If ABC chooses the
latter type of licensing arrangement, many more periodic
adjustments to it will likely be necessary. Specifically, in
addition to considering the preceding factors, ABC must determine
if actual experiences depart from the projections enough to imply
significant changes in the appropriate allocation of income. If
so, ABC will have to recalculate the sales based royalty rate by
substituting the relevant actual figures for the projections in
the preceding paragraph.
Example 11; Profit Split Method Using Information about
Relative Values of Preexisting Intangibles
Teachem is a U.S. corporation that designs, produces, and
markets educational toys in the U.S. It maintains a staff of
educational psychologists and engineers to develop and design the
toys, which are perceived as uniquely high quality and sell at a
premium. Enseignerem is a wholly owned affiliate of Teachem and
is incorporated in country F. It is one of the largest toy
companies in Europe. It was, and still is, the largest toy
company in country F when it was acquired by Teachem a number of
years ago. Enseignerem incurs large advertising and other
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marketing costs to develop its trademark and reputation as a
producer of high quality educational toys. It is responsible for
its own marketing strategies, which are different in important
respects from Teachem's marketing efforts in the United States.
For example, Enseignerem maintains a large sales force that calls
on schools and other institutions, and institutional sales
account for a much larger proportion of its revenues.
Teachem has recently developed a new line of electronic toys
and intends to license the European rights to the designs to
Enseignerem. Teachem does not plan to license them to any
unrelated parties; therefore, an exact comparable is not
available. Further, Teachem expects that Enseignerem will be
able to capture its usual high market share, especially in the
institutional market, and will be able to sell the toys for its
usual significant premiums over its competitors. For these
reasons, Teachem decides that suitable inexact comparables will
probably not be available.
Teachem next considers the basic arm's length return method.
Enseignerem will perform three functions with respect to the new
line of toys. It will be responsible for manufacturing them;
specifically, it will negotiate contracts and supervise
independent contract manufacturers who will actually produce the
toys. Second, it will distribute them. Third, Enseignerem will
be responsible for all aspects of marketing them.
The first two functions can be analyzed under the basic
arm's length return method. Teachem projects that the new toys
will sell for $100 each in Europe. Payments to the contract
manufacturers will be approximately $40 per toy. Enseignerem has
found that distribution costs, including transportation and costs
of holding inventories, are usually one-half of production costs,
and expects that the new line will be typical in this regard.
Therefore, Teachem projects that distribution costs will be $20
per toy. Finally, Enseignerem expects to incur costs of four
dollars per toy relating to the supervision of the contract
manufacturers. These costs include the salaries of engineers who
will be assigned to visit and test the contractors, and premiums
for liability insurance.
In some of its product lines, Enseignerem employs contract
manufacturers who are willing to distribute, as well as produce,
the items. By comparing these contracts with those calling for
manufacturing only, Teachem concludes that the independent firms
that perform distribution earn a return for it equal to 25
percent of the distribution costs. Teachem therefore allocates
five dollars per toy to Enseignerem for the distribution function
($5 - $20 X 0.25). Teachem also decides that a 25 percent
income-to-costs ratio is appropriate for the first function.
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responsibility for manufacturing. Thus, Teachem allocates one
dollar per toy to the affiliate as the return for performing it
(SI = 34 X 0.25).
Teachem decides that the affiliate's final function,
marketing, cannot be analyzed by the basic method. Enseignerem
is not planning to incur any significant costs attributable
solely to the new toys. In general, it focuses its advertising
on promoting the Enseignerem reputation rather than displaying a
single item, and does not plan to issue a separate catalog or set
up a separate sales force for the new line. Therefore, Teachem
decides that it is not possible to identify or measure the costs
or assets that Enseignerem will devote to the new product line.
However, it would clearly be wrong to conclude that Enseignerem
deserves no return for the marketing function, because its
preexisting reputation, sales force, and knowledge of its market
are crucial to the success of the new product line in Europe.
Therefore, a profit split is necessary.
To summarize the analysis to this point, the toys are
projected to earn a gross profit of S36 each ($36 = $100 - $40 -
$20 - $4 ) . Of this amount, six dollars should be allocated to
Enseignerem for the functions analyzed with the basic method.
Thus, S30 per toy is left as the combined return to Teachem 's
product designs and Enseignerem' s trademark, sales force, and
other marketing intangibles. The next step is to split these
profits in a way that reflects the relative economic values of
these sets of intangibles.
Teachem concludes that the new line of toys is similar to
other lines that the corporate group has introduced in the past
few years in terms of the importance of the underlying design
relative to marketing intangibles. Specifically, the designs
involved a typical amount of research and development effort and
the toys will be marketed in ways similar to, and with similar
intensity as, other products. Teachem analyzes its own
performance record and educational toy industry information on
the relative importance of design and marketing intangibles
therein. Based on a good faith analysis of this data, Teachem
concludes that it is reasonable to assign a relative value of the
design intangibles equal to one-half the value of marketing
intangibles. Accordingly, it allocates ten dollars of the S30 to
be split to itself and the remaining $20 to Enseignerem.
Teachem can structure the arrangement in any form that
achieves the appropriate allocation of income, ten dollars per
toy to the parent and $20 to Enseignerem. Specifically, it could
establish an agreement in which Enseignerem pays Teachem a
royalty for the European rights to the product designs at a rate
of ten percent of sales. In future years, Teachem must reexamine
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its arrangement and, if any key element in the analysis described
above changes significantly, must adjust the royalty rate
accordingly.
Example 12: Likely Use Of Profit Split Method
The research staff of a European company that manufactures
and markets food products has just created a chemical compound
that will alter the way that the human digestive system reacts to
sugar. The company believes that by adding the compound to its
products, the products will pass through the human digestive
system without being absorbed. The compound is unique because it
leaves the taste of the product unchanged. No information is
known about the possible side effects of this compound. The
company wants to use this discovery to offer a whole line of diet
products. The European company has a U.S. subsidiary that
presently manufactures and markets existing products in the
United States. The U.S. subsidiary also has a research staff.
Because the prime market for this new product is the weight-
conscious United States, the parent licenses the compound to the
U.S. subsidiary for development and for the extensive and
expensive testing that will be necessary in order to obtain
approval from the Food and Drug Administration. Because the
product is unique and because the subsidiary performs such
complex functions, the profit split arm's length return method is
probably most appropriate.
Example 13: Periodic Adjustments to Reflect Changes in Functions
A U.S. corporation produces and markets widgets in the
United States and it has a subsidiary in country X that produces
and markets widgets in Europe, The U.S. parent is in the early
stages of developing a new super-widget. In 1988 it is clear
that this could be a major breakthrough in widget technology;
however, the manufacturing process is still cumbersome. It is
unclear whether the process can be developed to the point that
it would be possible to mass-produce the super-widget. The U.S.
parent believes that the team of employees at its subsidiary in
country X is best suited for the time-consuming and expensive job
of developing the process to produce the super-widget.
In determining an appropriate transfer price for the license
of the technology, the parent can find no inexact comparable for
the super-widget. Similarly, the basic arm's length return
method is not feasible because neither party is performing
standardized functions. Therefore, the U.S. parent attempts a
profit split analysis.
Based on the best information available in 1988, the U.S.
corporation predicts that the development process should be
completed by 1994. An increasing number of super-widgets will be
produced between 1988 and 1994; however, only in 1994 will true
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assembly-line style production be feasible. Based on an analysis
of the relative costs incurred by the parent and by the
subsidiary, and on an analysis of the relative returns earned by
unrelated parties when risky products are Jointly developed, a
50-50 profit split on the returns of the design of the super-
wldget is adopted by the parent.
By the end of 1989, as the parent is filing its 1989 tax
returns and is rechecking its transfer price policy for 1990,
super-widgets are being successfully mass-produced at close to
the volume predicted for 1994. Instead of requiring the extended
development process predicted two years earlier, establishing
production was more similar to the effort necessary when
adjusting production lines for improved versions of products.
Accordingly, the parent adjusts its transfer price policy to a
basic arm's length return analysis for its subsidiary in country
X. Specifically, the parent determines the average rate of
return earned by independent companies that manufacture a product
similar in complexity to super-widgets. Because the parent is
particularly cautious and feels it would be difficult to sustain
its profit split for 1989, it also modifies the 1989 policy to a
rate of return analysis. While at the outset of this transaction
it appeared that the subsidiary in country X would be required to
use significant intangibles of its own to establish the
production process, the actual experience of the parties was that
no unique intangibles were contributed by the subsidiary. The
decrease of five years in the time expected to develop production
to the 1994 level constitutes a significant change that requires
an adjustment.
Example 14: Periodic Adjustments to Reflect Changes in
Indicators of Profitability
A U.S. pharmaceutical company has patented the formula for a
new anti-arthritic drug with fewer side effects that those in
existence. The U.S. parent's subsidiary in country Y will
manufacture the drug and market it worldwide. There are numerous
third party licenses for the existing anti-arthritic drugs. The
parent decides that these products are comparable because it
feels that its product will be a close competitor to them, and
will sell for a similar price and capture a similar market share.
Specifically, it believes that its drug will capture
approximately 15 percent of the market, as do several of the
existing products. The parent uses the eight percent royalty on
net selling price that is found in those licenses and adopts
other significant features of such licenses as well. For
example, the length of the agreement is for the length of the
patent.
The U.S. parent reviews its license with the subsidiary at
the start of year two and finds that its drug has only an eight
percent market share. However, the market share seems to be
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continuing to grow. Indeed, at the beginning of year three its
market share is 16 percent and at the beginning of year four its
market share is 21 percent. In each of these years the U.S.
parent decides that the inexact comparable is still appropriate.
By the end of year four the popularity of this drug has
skyrocketed and it captures 50 percent of the market. Since
this share of the market is far beyond that captured by any of
the third party licenses, it can no longer be assumed that the
level of overall profitability for the product licensed to the
related party is similar to that for the products licensed to
unrelated parties. Specifically, to the extent that market share
is an indication of the mark-up that can be charged on a product,
the related party product, which captures 50 percent of the
market, is probably much more profitable than products that
capture only 15 percent of the market. Therefore, the present
inexact comparables are no longer valid. A search for other
inexact comparables fails to produce a license involving a
similar market share. Therefore, the parent turns to a basic
arm's length return analysis to determine what its subsidiary
should earn.
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